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Weekly Bitcoin Price Update and A discussion around Hedging

by · 1 year ago

Thanks for taking the time to sign up to this letter which I am intending to use moving forward to give more of an insight into thoughts on the market and to cover off finance topics which people have frequently requested that I cover. The audience is broad which I have attempted to take into account as well as the amount of time people are willing to invest in digesting this letter.

This is the first issue and I have focused it less so around the Bitcoin market, where I have been giving regular updates in my Telegram group and have instead included a fairly extensive piece on hedging; what is it and how is may broadly be applicable in this industry and in general.

Rightly or wrongly, I’ve not taken the time to look at another newsletter or issue product, with the intention being to keep this unique to my style.  Please also bear in mind that this letter is not intended as advice and should not be an inducement to take any particular position in the market.

Moving forwards, this will be the place I provide full market analysis.  Over time, I plan to evolve this to be beyond the Bitcoin market and introduce various other techniques to rapidly cover off opportunities in the Crypto and traditional markets, but this is an evolutionary process and lets do one thing at a time; I wanted to get something off to you before I go on vacation.  I will do a longer update on Bitcoin next week.

Any questions comments or feedback would be appreciated; I hope you find some value in here and if you do – share the sign up with someone at decentrader.com

Bitcoin Market Technical Analysis

What happened this week;

The most notable move in the Bitcoin market this week is the reconquering of the $10k handle following a double bottom above $9k and failed selloff on Sunday night.

Despite personally remaining cautiously bearish overall due to market structure on higher timeframes, the market did provide some early key indicators that we were looking less likely to dump off towards $8k in the short term, which I pointed out in Telegram.

There were a few giveaways probably worth noting for future reference;

  1. The divergence in the spread between the December futures contract and Spot started to arise some suspicion that the market was not ready to dump [as illustrated in the chart below]. What I mean here is that the futures price was increasing relatively while the spot price was remaining stagnant.
  2. Everyone was bearish due to the overwhelmingly short term technically bearish market structure on the daily and weekly chart; i.e. sentiment was overly bearish while there was a potential double bottom at work.
  3. The Dauth maul candle on Sunday night was “won” by the bulls; I rightly or wrongly have a general rule with a market testing move like this, that whichever side the candle ends up on, is most likely to be the side to which the market moves.   Ultimately it demonstrated that the selloff failed to invoke a market collapse and when it was bought up, the price actually moved higher – this isn’t what you would expect from a house of cards ready to implode.

As such, this enabled some long scalping against my short positions; however I remained short around $10k and had to phase out as we moved higher last night.  Overall a profitable trade, but could have been better.

 Failed Selloff and Futures Divergence https://www.tradingview.com/x/2hSrmqjQ/

 Looking forward to the weekend

The futures premium has now recovered to $300 – a level which has not been seen since we were up at $11.2k and may serve to be indicative as what is next to come for bitcoin.  There is also an Adam and Eve bottom pattern forming on lower timeframes, implying a measured move towards $12-12.9k would be possible.  However, as we know all too well from 2018, these can fail and become rather nasty bull trap.  Ideally, we need to see a sustained and supported break above the $11k level before this becomes tradable with bigger size, with a measured move looking to take us across $12, possibly retesting the $13k handle.

Bitcoin looks as though it will almost inevitably try to test $11k this weekend, and I will be looking for opportunities to trade long to this level but will not hold positions beyond this until there is confirmation that we will move higher.  I am looking to be long around $10.3k with a stop below $10.1k, targeting around $11k which is a risk to reward of around 2 and will cover this on Telegram.

Futures Premium, Adam and Eve Target and Failed Selloff https://www.tradingview.com/x/1ASzA44M/

Weekly Chart

I have covered off the macro view in an extensive 12 month bitcoin forecast post on Tradingview, but I wanted to just show what Bitcoin is up against in the immediate future and why the Adam and Eve may turn out to be a trap.  On the weekly timeframe, bitcoin has support at $9.5k and faces resistance at $10.6k and again at $11.5k.

Overall, Bitcoin needs to start trading in the $10.6-$11.5k range.  Ideally we would do well to close the week above $10.8k where there was previous weekly support.

Therefore, I am paying particular attention to these key levels, rather than getting blindsided by the lower timeframe market structures. As we receive confirmation at these key levels, it will serve as a strength indicator and imply it will be more suitable to increase size.

Also not shown here is that Bitcoin is currently battling to avoid a MAC-D weekly cross; this has served to invoke a selloff in both bear and bull markets on the weekly in almost all instances, so should this arise, it will be another important indicator as to which direction this market wants to move.

Overall, I remain in my view that Bitcoin is in the early stages of the bull marked – the stealth and smart money phase.  Congratulations if you managed to take the ride up so far through 2019, but the market is at a point of indecision and appropriate risk management should be applied; I plan to let the market do the leading.

Weekly Support and Resistance in the Bitcoin Market

Hedging

The concept of hedging is mentioned in various differing capacities within the space and is something that I am often questioned about.  I hope to try to simplify it and explain what it is, when it may be utilised and how it may be executed.  This list could be exhaustive and the audience of this letter is broad, so I will approach it in ‘one size fits all’ approach.  There is no right or wrong way to hedge and similar outcomes can be achieved via various differing financial instruments or methods.

Hedging; What’s it all about?;

Hedging is a process which is utilised to mitigate financial risk, that being; a risk of a change in a financial condition such as an exchange rate, interest rate, credit rating of a customer, or price of a good/service.  Hedging is also applied to mitigate portfolio risk; that is in an attempt to mitigate systematic risk; risk being inherent in a specific company, commodity or industry.

Benefits of Hedging

The simple purpose of hedging is to introduce a level of certainty into an otherwise uncertain situation;

  • It can provide certainty
  • Certainty creates confidence
  • Certainty and confidence both enable and encourage investment decision making
  • Tax benefits

Issues with Hedging

  • Transaction costs may be significant
  • Lack of expertise to deliver an effective strategy
  • Opportunity cost of certainty vs speculation
  • Tax complexities

Traditional Application

One of the most typical applications may be found via portfolio diversification; that is, by limiting exposure to a single market, commodity, equity, currency etc and is the aim of most fund managers and hedge funds themselves.  It enables a scenario whereby money can be made overall by setting off risk of one asset against another.

Financial institutions and businesses also seek to eliminate risk mainly via the utilisation of their treasury function to mitigate liquidity/funding risk (e.g via utilising credit from various sources), counterparty risk, (e.g. exposure to a single holding entity), Foreign currency risk and interest rate risk (e.g un fixed interest bearing loans).

Multinational Businesses take consideration over where to deploy operations to mitigate political and economic risks introduced by trading in one market, or focusing their supply chain operations exclusively to one country or region.

In essence it is clear that hedging is a wide topic with a huge number of applications.

Application to Bitcoin Trading / Crypto Operations

I will cover off what I believe to be the most relevant points to understand for the most typical individual in the bitcoin space; some of them are ‘nice to knows’, some technical, but I am certain there is a parallel somewhere below for all people reading this letter.

One important point to note is the time and effort invested in performing an effective hedge and it must be taking into consideration as a cost when deciding to take the hedge; i.e. if your position is relatively small there may be no point in taking action, or, if being invested in crypto is your hedge against the banks or whatever then you have already executed your strategy.

Trading

I will begin with hedging in trading as this is something that I frequently discuss when utilising my trading indicator but generally I’m often executing hedging strategies in the background.  Please note that you need to ensure that you understand what the tax implication is of taking action when executing different methods as what may be efficient in one jurisdiction, may not work in another.

I will use a few hypothetical situations

1. Mitigating spot risk utilising Derivatives to find enhanced tax effiencies. 

  • Lets suppose you had bought 1 physical bitcoin at Coinbase as bitcoin broke $4k and headed to $13k.
  • You wanted to cover at $13k because this was the 61.8% retracement level of the 2018 bear market and it was a place to start introducing some risk management, but you are of the opinion that bitcoin may continue to $20k but are not certain and are fearful that the price could return to $8k.
  • One way you could achieve this is simply by selling your bitcoin at $13k and going into cash; the benefit of this is that you introduce certainty.  The disadvantage is that you almost certainly create a taxable event. Chances are in your jurisdiction that you would be exposed to tax on the $13k-$4k i.e. $9k of profit. Lets say the tax rate is 30% and therefore the tax owed is $2.7k.
  • Another way you could achieve this is by sending the bitcoin across to Bitmex or utilising another derivatives exchange and simply entering into a 1 bitcoin short position derivative contract.
  • You short bitcoin with 13000 contracts and hold onto the position all of the way to $8k; in doing so you make a return of 0.625 BTC, which in USD terms offsets the USD value lost, yet you have not sold your initial 1 bitcoin bought at $4k.  Therefore your 0.625 BTC gain is worth $5k when you close your position.  The tax man would like his 30% which would mean a taxable $1.5k owed – this is therefore more efficient than the $2.7k liability in the simple spot sale.
  • It is important to understand the tax scenario in your jurisdiction so best to seek advice regarding this, for example there are considerations needed around capex allowances, the handling of derivatives tax vs. capital gains tax and legalities and advantages around certain financial products used etc.
  • There is also the cost of delivering the hedge itself, which is likely to be the funding cost of the XBT short contract.

2. Utilising futures contracts to take advantage of Contango 

  • In simple terms, contango is a term used to describe where futures contracts prices are higher than the current spot price.
  • Typically contango arises when a market is appreciating and the expectation is that the price will be higher in the future.
  • This premium usually reduces when there is lowering expectation of prices which comes about when spot price reduces.
  • It is referred to as backwardation where futures price is lower than spot
  • Continuing from the above example, the futures contract ending in December 2019 has a premium of $800, which was the actual scenario when bitcoin was at $13k.. i.e. the contract price for one bitcoin was $13.8k
  • Instead of hedging the spot based contract by selling 13000 contracts, you sell 13800 futures contracts.  This could be done via various different vehicles, each with differing advantages and disadvantages and creates complexities in itself around size by using something like Bitmex, but ultimately you want to arrive at a scenario where you agree so sell at the futures price which could actually be easiest utilising CME contracts -a topic for another day.
  • As in the previous example, price moves towards $8k, but the premium on the futures contract which was $800 has now been eliminated, meaning that instead of making a taxable gain of $13k-$8k = $5k you make $13.8k-$8k = $5.8k.
  • In essence premiums on futures can offer opportunities when the price is running away faster than the spot price.
  • There are several other mechanisms available to utilise futures to hedge an existing position in particular using an arbitrage process known as cash and carry this is a relatively complex topic for another day as it goes beyond simply hedging, but I wanted to include this as I do passively refer to it in my trading.

As a side note, I often take on offsetting positions using futures contracts when I am overall bullish with a long on the market, but I am of the opinion we are due a pull back and I think futures prices have run away too fast.  I use this technique to maximise my potential gain when futures ultimately react and come back towards spot meaning that the effective short term trade has more upside risk than simply going into cash and rebuying.  Sometimes I do this with an equal and opposite amount i.e. I fully hedge; sometimes I partly hedge the position and sometimes I just close out the long position if there is a costly funding rate attached to the spot, which outweighs the expected benefit from shorting futures contracts.  Each time I do this all these components need to be considered.

Using derivatives and leverage to hedge counterparty risk

  • There is the old “not your keys not your coins” phrase used in the crypto space which is effectively describing counterparty risk holding coins on a third party exchange where in essence you become a creditor.
  • By utilising leverage, it means that you do not have to hold all of your coins on an exchange to be exposed to the full size that you may want to achieve.
  • For example, you may have $100k USD but do not trust the exchange.  Therefore, you may send $10k to the exchange and leverage the position long 10x meaning that you are exposed to $100k value of bitcoin but you are only risking $10k value on the exchange.
  • There will be an interest cost associated in loaning the additional $90k but you may have decided that this cost is worth utilising to cover off the risk of the exchange going bust.
  • Similarly, this technique may be used to hedge a cold storage stack, where not all of the coins want to be moved, but there is a desired to cover some of the USD value of the coins.  This means that not only are not all the coins able to avoid being exposed to a tax exposure event as described earlier, but there is also the advantage of not having to introduce significant counterparty risk.
  • Please note that again using leverage introduces other complexities and potential risks which need to be fully understood before utilising.

This covers off the most commonly used techniques which I employ in typical trading of a single crypto asset.

Portfolio management

I described earlier that being exposed to one asset class or even one asset within an asset class introduces systematic risk.
Typically no one should be ‘all in’ on crypto and a balanced portfolio approach should be applied.  Crypto is often seen as the hedge itself against the financial system. It is also seen as a speculative asset class, which again makes sense to include as part of an investment portfolio.  The extent of the exposure most likely depends upon the life cycle of an investor; for example it makes sense for a younger person to have a larger exposure to a risky asset than a younger individual.

Regardless, the point I am making is that crypto ‘is a hedge’ but also investors want to hedge within their exposure to crypto itself by investing in other crypto assets to mitigate failure risk and to enable potential upside risk; same as any other asset class.

This is a particularly emotive topic as there are those who insist on Bitcoin being the only asset to invest in.  I don’t want to comment on this in detail but my view is that any reasonable cryptocurrency portfolio should have most exposure to Bitcoin.  The reason for this is that it is well documented that if Bitcoin suffers depreciation; the other assets perform even worse. Bitcoin is widely viewed to be the asset most likely to succeed, having first mover advantage and a unique value proposition.

I’m relatively comfortable in saying that Bitcoin will always make up at least 80% of my exposure and should alternative crypto assets gain greater value relatively within my portfolio in bitcoin terms, I will rebalance accordingly.

Counterparty Risk

I briefly touched on this earlier but I will cover it off as it is important to include a few points re “not your keys; not your coins”.  Ideally, we all know that assets should not be kept on an exchange; particularly short investment positions.  However it is also worth noting that any trader trading significant size intending to partake in market marking activities should ensure that they have split their assets across various exchanges to mitigate risk to a single entity; this may seem obvious but it’s surprising how few apply these basic risk mitigation strategies.

Mining and other business operations

This is one of the topics which I have talked about a lot regarding the implication on the bitcoin price.  You can find some of these articles in detail on Tradingview and how I believe it will impact price, so I will keep it brief;

Miners who buy equipment with the intention to produce Bitcoins have exposed themselves to the cost of investing in hardware.  They know roughly what their production output is likely to be due to mining difficulty and the extent to which that is likely to increase based on competition and new hardware coming online.   If a miner has bought a miner and knows that it is likely to be able to produce a diminishing number of X bitcoins in each quarter of the year, the miner is able to lock in the value of each of these expected bitcoin production outputs today by shorting the future price of these X bitcoins (assuming they have the necessary collateral to do so). This means that irrespective of the price of spot Bitcoin in the future, when they are produced, the value of the bitcoin is locked in and the miner is provided with certainty that they will be profitable.  There are many ways to do this, with physical contracts most likely being preferable.

As a very simple example using Bitmex Futures contracts;

Miner A believes they will be rewarded with 100 BTC in Q3 2019 for a miner they have procured.

Bitcoin Price today is $10k – the price when the assets are produced is uncertain; some people in the space are speculating that BTC could return to $1k *rolls eyes*

The miner enters an agreement to sell 100 BTC at $11k at the end of Q3 meaning that the total value of the contract entered will satisfy the value of the investment in the capital and therefore it will be a profitable venture; they short sell 1.1 million contracts (100×11000 contracts).

By the end of Q3 bitcoin’s price is $8k and the miner takes his 100 BTC to the OTC market and sells them; the miner receives $800k, he also closes out his short position on the futures contract and makes $300k; i.e they receive the $1.1m value irrespective of the underlying price.

The benefit here obviously is that the miner has locked in a profitable position, which may mean that they are confident enough to go and take on additional loans to purchase more equipment to accelerate their growth; i.e. its enables certainty which can enable other perpetuating profitable investments.

There are many different ways this could be achieved; indeed, the OTC market could have delivered the entire of the deal end to end and new physical contracts such as Ledger X and Bakkt coming to the market may provide the most effective way to achieve the desired output.  I am merely describing one way of many in going about this task.

I’m not a miner in the bitcoin space but I have managed exposure to mining and trading operations in the physical world.  I don’t know exactly how miners operate in this space, but I suspect that its not hugely different to the real world; – there will be a level of speculation that goes on and I suspect that miners will cover off a basic cost base and then let the rest ride and trade it at an opportunistic moment.  This will potentially lead to scenarios where large volumes of coins may be amassed and withheld from the market which will influence spot price.  There may also be some incentive to collude; either consciously or otherwise to ensure prices reach certain levels by halving dates to ensure equipment may be profitable moving forwards.  All of this I have talked about previously and I discuss in the ‘Economics of the bitcoin cycles’ which is available on Tradingview.

See you next week!

Best
Filb