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Trading the Bitcoin Craze Without Getting Hurt

As great a year as stocks experienced in 2017, the new digital currencies (known as “cryptocurrencies” because they utilize encryption to prevent computer hacking) performed even better.

Much better.

The Amazing Price Appreciation of Cryptocurrencies

Whereas the S&P 500 gained 20%, the cryptocurrencies of bitcoin, Ripple, Ethereum, and Litecoin have gained thousands of percent each.

Security Name

Dec. 31, 2016 Closing Price

Dec. 31, 2017 Closing Price

Percent Gain

Ripple (XRP)

$0.0065

$2.30

35,385%

Ethereum (ETH)

$7.97

$756.73

9,495%

Litecoin (LTC)

$4.33

$232.10

5,360%

Bitcoin (BTC)

$963.74

$14,156.40

1,469%

S&P 500 (SPX)

$2,238.83

$2,673.61

20%

 

Wow.

Was 2017 a fluke year? If you look at bitcoin’s price history, the answer is no. Bitcoin’s trend has been bullish for several years:

BITCOIN ANNUAL PRICE PERFORMANCE

Year

Percent Return

2011

1,473%

2012

186%

2013

5,507%

2014

-58%

2015

35%

2016

125%

2017

1,469%

 

Is it guaranteed that Bitcoin will rise again in 2018?

No.

The cryptocurrency actually fell during the 2014 calendar year and that could happen again. Just last month bitcoin experienced its worst drawdown in more than three years — a nauseating 45% intraday plunge in the span of only five trading days between Sunday December 17th and Friday December 22nd due to insider infighting that threatens to fragment the bitcoin currency into separate and incompatible offshoots.

On the other hand, as incredible of a gain as bitcoin experienced in 2017, it actually experienced even greater percentage gains in 2011 and 2013, so the sky remains the limit as to what is possible.

Bitcoin Has Fixed Supply, But What About Value?

The supply of bitcoin is currently about 16.8 million units and there is a fixed limit of 21 million units that analysts forecast will be reached by 2140. The fixed supply of bitcoin makes bitcoin more like gold than like the paper money of governments, which can be printed at will (i.e., “fiat” currency).

A fixed supply means that bitcoin acts as a “store of value” and won’t depreciate from inflation. The high current unit price of bitcoins is not a problem because people can buy and sell fractions of bitcoins called “Satoshis,” which are named after the pseudonym of bitcoin’s founder or founders, Satoshi Nakamoto. Each bitcoin can be divided into 100 million Satoshis.

But to be a real store of value requires more than a limited supply; it also requires that it provide actual utility. A limited supply of trash is still trash. Like gold, cryptocurrency generates no cash flow in the form of interest, dividends, or earnings, so there is no “intrinsic” value to cryptocurrency; it’s only value is what someone else is willing to pay for it.

The real utility of cryptocurrency could be nefarious; the anonymity it provides to its users outside of the global financial monetary system facilitates criminal activity such as tax evasion, money laundering, drug dealing, terrorism, and extortion. Several cryptocurrencies provide more anonymity than bitcoin, so if criminal anonymity turns out to be the real sustainable advantage of the cryptocurrency revolution, bitcoin will end up a big loser.

Bitcoin also suffers from a relatively slow transaction time averaging 78 minutes because of its small 1 MG block size of data, which has caused users to switch to other non-compatible cryptocurrencies such as bitcoin cash, which offers an 8 MG block size of data.

Bitcoin is a Speculation, Not a Currency

Anything that rises more than 1,000% in a year’s time is speculative at best and a fraud or criminal enterprise at worst. The price is rising so fast because people are buying bitcoin not for its utility as a currency or a store of value, but simply because they are betting that they will be able to sell it for more than they bought it for.

For a currency to be an effective mode of exchange, its value relative to other currencies must remain somewhat stable so that buyers and sellers can anticipate the value they are receiving in exchange for their goods and services both now and in the future. So far, none of these cryptocurrencies qualifies based on price stability.

The greater fool theory works until it doesn’t, and I don’t want to be left holding the bag. The final price of any particular cryptocurrency could be zero. On December 11th, the U.S. Securities and Exchange Commission (SEC) warned consumers about the dangers of cryptocurrencies:

A number of concerns have been raised regarding the cryptocurrency markets, including that, as they are currently operating, there is substantially less investor protection than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.  

Please also recognize that these markets span national borders and that significant trading may occur on systems and platforms outside the United States.  Your invested funds may quickly travel overseas without your knowledge.  As a result, risks can be amplified, including the risk that market regulators, such as the SEC, may not be able to effectively pursue bad actors or recover funds.

It may be nearly impossible to counterfeit a cryptocurrency, but it remains very easy for your cryptocurrency to be stolen given both the lack of insurance and the lack of regulation of bitcoin dealers. Your stocks and bonds are safe because U.S. stock brokers are regulated custodians and the federal government through the Securities Investor Protection Corporation (SIPC) provides $500,000 of insurance per account.

With unregulated and uninsured bitcoin brokers, caveat emptor.

Two Ways to Invest in Bitcoin Directly

Two bitcoin vehicles currently exist that provide some regulatory protections, but neither is ideal.

  1. Grayscale Bitcoin Investment Trust (Other OTC: GBTC) trades over-the-counter (OTC) rather than on a formal exchange. Not a deal-breaker, especially since it trades on the highest-level OTCQX market, but there are fewer investor protections and worse bid/ask liquidity in the OTC markets.

More troubling is the fact that the trust does not track the actual price of bitcoin with any accuracy and currently trades at a huge premium of more than 50% to the net asset value (NAV) of its actual bitcoin holdings. With competing fund products soon to come out that track bitcoin’s value more closely, the risk of a GBTC investor suffering both a collapsing bitcoin price and the elimination of the NAV premium is a recipe for a double disaster.

In November, Andrew Left of short-selling firm Citron Research began recommending an arbitrage pairs trade where you buy bitcoin futures (see below) and sell short GBTC, which will generate big profits when the GBTC premium to its NAV collapses.

Lastly, the custodian of GBTC’s bitcoin holdings does not carry any insurance, and the trust accepts only limited liability for losses, so if the bitcoins get stolen investors could be left with virtually nothing.

2. Bitcoin futures contracts are traded at both CBOE Holdings and CME Group.

 

Exchange

Bitcoin Ticker Symbol

Number of Bitcoins Per Contract

Margin Requirement

CBOE

XBT

One

44.0%

CME

BTC

Five

47.3%

 

Stockbrokers that enable trading in either or both of these bitcoin futures contracts include e*Trade, Interactive Brokers, TD Ameritrade, and Tradestation.

I see two problems with these futures:

(a) You can’t buy fractions of a bitcoin, so it is very expensive to participate. With a single bitcoin currently trading for about $15,000, a person is on the hook for $15,000 buying one XBT contract and $75,000 buying one BTC contract. Not all of that liability must be paid up-front, however, because the margin requirement is less than 100%.

But . . .

(b) The futures exchanges are charging extremely high margin requirements and stockbrokers are requiring much more margin than the exchange minimums. For example, TD Ameritrade requires 1.5 times the exchange minimum in margin, so one XBT contract requires $9,900 ($15,000 * 44% *1.5) and one BTC contract requires $53,212.50 ($15,000 * 5 * 47.3% * 1.5). That is way too much money for the average trader.

The main advantage of trading futures is a low margin requirement far below the full 100% cost of buying the asset outright, but the extreme price volatility of bitcoin has caused the futures exchanges and brokers to eliminate this advantage almost entirely with very high margin requirements close to 100%.

As of yet, there are no options offered on the bitcoin futures, so the low-cost leverage of options isn’t available to cure the high-margin problem. Ugh.

Instead of Bitcoin, Buy Blockchain

I would not trade bitcoin. Better to trade the underlying “crypto” technology known as blockchain, which uses complex mathematical complications to verify transactions and prevent counterfeiting. Such a verification system in the digital world is much needed and could be used for many types of cybersecurity applications beyond currencies. Several stocks can be bought to gain exposure to blockchain, but that discussion must be reserved for another day.

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