Along with altcoins, bitcoin is still establishing its role in the market. From a theoretical perspective, blockchain remains a new technology. Developers have an exciting technology still in the process of proving itself.
From an investor perspective, cryptocurrencies have not yet stabilized. This is a market in its infancy, realistically less than three years old, and it shows. Cryptocurrency today rides the roller coaster of dot-com companies in the late 1990’s. Money is pouring into the marketplace fueled by a combination of grounded enthusiasm and utopian evangelism. Just like the dot-com bubble, this will lead to some people getting rich and others losing their shirts before the industry finally settles into fair valuations.
Bubble Management Stock Market-Style
In the stock market, short selling plays a major role to correct bubbles like this. By allowing investors to make money off of devaluing overvalued stocks shorts help to break speculation feedback loops. Per Investopedia:
“Short selling strengthens the market by exposing which companies’ stock prices are too high. In their search for overvalued firms, short sellers can discover accounting inconsistencies or other questionable practices before the market at large does.”
The same process works for commodities. Short positions in the futures market allow a commodities trader to profit off of falling prices. As with stocks, this lets traders flag overvalued assets and profit without participating in speculative price booms. It is a corrective mechanism that bitcoin, for all of its enthusiasm, badly needs.
Any asset, no matter how valuable, needs something to occasionally pump the brakes.
Although bitcoin does currently have a nascent options exchange, it remains aggressively low-volume. That should change. More importantly, much as bitcoin needs a futures market, traders need one too.
Because when it comes to bitcoin, the most stable way to invest is through futures. (Note to the reader: Options contracts, while distinct from futures, are similar enough that this piece uses the term “futures” for the duration of this article.)
As we discussed recently, cryptocurrencies like bitcoin operate like a commodity from the perspective of investors. They mirror both the fundamentals and the volatility of assets like gold and other precious metals. So when traders approach the cryptocurrency segment of their portfolio, they should consider their position like a commodities trader, not an investor.
For a commodities trader, volatility is the name of the game.
Successful Commodities Trading Requires Volatility
Take gold, for example. One of the most stable commodities because of its (diminishing) role as a reserve asset, it still has volatility that has ranged from 4 to 40 percent per quarter since 1970. This kind of price fluctuation is virtually unheard of for corporate shares, but it pales in comparison to other major assets such as soybeans (10 to 75 percent), crude oil (12.63 to 90 percent) or silver (10 to 100 percent). This is a baked-in feature of the commodities market, due in part to relatively inelastic supply and pricing based primarily on market demand.
This volatility means that commodity traders don’t typically buy and hold an asset the same way that investors do. With the exception of gold, it’s rare to see a trader purchase, say, one ton of coffee and wait to sell those beans for a higher price.
While this model works quite well in the steadier stock market, it would prove difficult on a commodities exchange. The price of coffee alone has fluctuated by more than 200 percent in the past 10 years. In the past year, it has jumped by 12 percent before diving by 30 percent, before ticking back up by five. Trying to re-sell a barrel of coffee beans in this environment would cause chaos for the average trader.
This uncertainty infects bitcoin trading as well, with the cryptocurrency’s often unpredictable highs and lows.
Futures Leverage Bitcoin’s Volatility for Profit
To deal with this, commodities traders rely on futures contracts. A futures contract allows the trader to invest specifically in volatility. Instead of having to predict the right price at which to sell, a futures trader invests in price direction.
Take coffee again.
In purchasing coffee outright, a trader would have to choose a purchase price and then decide at what price to sell. Both of these involve precision judgment calls. In a market that has more predictability, the trader can make a more informed decision about those price points. In the commodities market, when the price can skitter quickly, that’s harder.
Instead, then, a futures contract lets him peg a future price point. He can say that, whatever else the market does, he believes that in six months the price of beans will have topped at least $1.15 and build a contract around that. He has invested in direction, not price.
For bitcoin traders this kind of vehicle offers three chief advantages:
Advantage One: Trade Against Volatility
At the time of writing, Bitcoin had a 30-day volatility estimate of 2.53 percent. That’s on the lower end for the BVI, which typically rotates around 5 percent. In raw terms, the price of a single bitcoin has swung by thousands of dollars within the last year.
This makes it hard to figure out how and when, exactly, to sell your bitcoin. As with all commodities, the risk is always there. If you sell too soon, you may miss out on riches; sell too late and you may take a bath.
A futures contract helps with that. Built for volatile markets, the contract does not cap potential gains. A bullish trader can buy the rights to purchase bitcoins for $6,500 apiece and will profit no matter how high the asset goes. If it soars back up to $20,000, the profits are all locked in. Trades are made on direction and volatility, not price prediction.
Advantage Two: It’s Easier To Short
There are few, if any, easy ways to make money off falling prices when you hold a commodity. For this reason, markets like bitcoin tend toward speculation bubbles. Traders who want to participate really only have one option: investing their money into the asset. So they buy low and hope to sell high, pumping more value into a potentially unstable system.
Trading futures, on the other hand, allows you to make money off both directions of an asset’s swing.
Savvy investors can purchase “short” positions and profit when the price drops. For a highly volatile asset, this opens up far more opportunities to profit. For the market at large, it means many more early warning signs of instability.
What happened to bitcoin in December 2017 would probably have happened no matter what; however, there’s a good chance that losses could have been mitigated if investors could have had notice that cryptocurrency was overvalued. Short positions create an entire investor class built around providing that notice, while allowing individual traders to profit.
Advantage Three: It Allows Hedging
Finally, for traders who want to buy bitcoin directly anyway, futures contracts allow for “hedging.”
In hedging, investors who deal in the underlying commodity buy futures positions against their current holdings. An individual buying bitcoin would also buy short positions against the currency, while someone selling their bitcoin would accompany that sale with a long contract. This allows the trader to hedge his or her bets against future market movements.
If, not long after you sell your coins the price of bitcoin skyrockets, you’re still in a position to profit. By contrast, if the bottom drops out after you’ve made a large purchase, you have some security.
Futures contracts were invented, in part, to specifically deal with the volatility and unpredictability of the commodities marketplace.
They are a natural fit for cryptocurrency traders.
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