How to get rich trading Bitcoin

Bitcoin exchange Bitstamp suffers $5 million hack attack

As an observer of the Bitcoin market as long as this original cryptocurrency has existed, it never made much sense to me from an investment perspective. Bitcoin prices were too volatile and the volatility seemed too random. Volatility can be a good thing for traders, mind you, but only if you think you have an idea why the price goes up and down the way it does. Otherwise it is just a good way to lose all your money. But a couple of recent events have changed my view of Bitcoin. I now think I can explain its volatility and predict it well enough for profitable trading. And the best part is that it takes no rocket science at all. Your mother (and mine) can make a living trading Bitcoins.

For those who don’t know, Bitcoin is a stateless currency based on blockchain calculations. There will only ever be 21 million Bitcoins and only 16-odd million of those have so far been "mined." The present value of all mined Bitcoins is around $18 billion, which is amazing if you realize they came from nowhere and have no intrinsic value.

My first realization about Bitcoins this year came among the annual predictions I publish every January. Here’s what I wrote then:

Prediction 7

Not the demise of Bitcoin, but finally an acceptance of what the crypto currency is (and isn’t). My son Cole, who is 12 (and now taller than me), was for awhile a Bitcoin miner. We bought a used Ant Miner last year on eBay, equipped it with a proper power supply and set it going 24/7 in the Man Cave, where most boyish things happen around here. The rig was incredibly loud and -- after the first electric bill arrived -- totally uneconomic. We were paying twice as much for electrons as Cole was receiving in Bitcoins for his labor. Anyone with a robust solar installation want to buy an Ant Miner?

Then a few weeks ago Bitcoin prices started to rise again and I saw Bitcoin stories with headlines like "Too Big to Fail." Yet what goes up seems to inevitably come down because Bitcoin prices crashed yet again a few days ago. This led me to a realization that I think is going to become popular: Bitcoin is an excellent transfer currency but as a longer term store of value it sucks and that isn’t likely to change.

Bitcoin is a great idea, blockchain is an even better idea, but since neither is backed by the full faith and credit of, well, anyone, a Bitcoin will always be a sorry substitute for a dollar or a yen. The price of Bitcoins will rise as folks in China find the need to use them to get money out of that country. But when their money finally is out of the China it is inevitably converted straight into dollars and the Bitcoin crashes as a result. So there may be some cyclical arbitrage opportunity in Bitcoins, timing the market to take advantage of the suckers, but as a true currency, Bitcoin will probably never cut it.

This says nothing about technical merit, mind you. What matters here is psychology and behavior. It’s the "full faith and credit" thing. Without it Bitcoin can’t be trusted to be any more than a short-term monetary value mule.

My second Bitcoin realization came last month when the SEC denied two separate proposals to create Bitcoin-based Exchange Traded Funds (ETFs). The SEC’s reason for the denials doesn’t matter here but it’s likely to stick even under President Trump, so don’t expect that situation to change. Bitcoin ETFs would have ballooned the currency’s capitalization as little investors piled-in like timeshare condo buyers. It would have been an easy win for those with large existing Bitcoin holdings like the Winklevoss twins, who were behind the first ETF proposal to go down in flames.

BIX-ETF-response (1)

Upon the news, Bitcoin dropped in price by 25 percent then recovered completely within two days! When the second ETF application was denied the drop was much smaller and the recovery even quicker. Some will say the market had already priced-in the SEC decision, but that begs the question of not why Bitcoin didn’t go down by much, but why it quickly continued to rise? This is what I think I’ve figured out.

I’m starting to believe Bitcoin can’t go down in value. I mean, it will be volatile of course and there will be many bumps in the road. But over time, it’s a good bet that it will continue to rise in value as the most popular cryptocurrency. If it loses that status then fine, it can go down, but something is going to win here and Bitcoin is the prime contender.

The first reason I say this is because there are two kinds of Bitcoin owners.

First are those poor sods who think it’s a store of value and the price will go up for unknown reasons. These folks are much like stockholders. There are only a finite number of shares of a given stock. When I buy one I slightly make the price go up. If I hold that share, I also ever so slightly put upward pressure on the stock price because my one share is not available for sale. Obviously, I’m (slightly) limiting supply.

Unlike stocks, however, there’s another kind of Bitcoin owner -- one who owns the currency only for a few seconds. You can spend Bitcoin at Dell (and lots of other places) to buy computers. Now what really happens is that I can convert Fiat currency to Bitcoin, send it to Dell (For the nice minimal transaction costs) and Dell instantaneously turns it back into Fiat. Dell and I hardly cared about Bitcoin: it was (as I explained in my annual predictions) a transfer mechanism, not a store of value.

Dell and I were Bitcoin owners for only a fraction of a second, but we were owners. We did indeed “limit supply” of Bitcoin for a very short time.

Amazingly, Dell and I were utterly insensitive to Bitcoin’s price. All we want is non-volatility for the few seconds we owned it. I don’t care if a Bitcoin is worth a dollar, a thousand dollars or a million dollars. I’ll buy the exact number of Bitcoins (or fractional bitcoins), send them to Dell, and they’ll turn them back into Fiat. As long as the USD to Bitcoin exchange rate remains relatively stable in that tiny timeframe, we accomplished our value transfer.

Realization number three -- Bitcoin transactions are increasing.

That is, more and more Bitcoins are being owned for fractional seconds. At some point enough transactions (especially big ones) mean a lot of Bitcoin is out of the supply pool tied up in transactions. Bitcoin gets harder to find if even for a few seconds. Hence you have to convince more people from the first type of owners (the stored value holders) to sell their Bitcoins back into the supply, driving prices up.

Bitcoin is having some high-transaction issues which might cause a technical downfall from what I describe, but in general, whichever cryptocurrency wins will end up ever-increasing in value because of a finite money supply and the scarcity of money itself!

That’s the micro view, now let’s look at the macro view of the same market. As I wrote in my prediction, a large part of the Bitcoin market -- the really big transactions -- are rich people in countries with capital transfer controls using Bitcoins to get parts of their fortunes out of Dodge and into some safer economy. There are lots of such countries and -- this is the important part -- there will always be lots of such countries. So whether it’s a Chinese cabinet minister or a Russian oligarch or someone from behind Door Number Three, there will always be some rich person trying to move a shiftload of money to safer ground.

This suggests my new Bitcoin trading strategy, which I admit I have only tried so far on paper. Here’s how it works. Bitcoins go down in value when the demand for them as transaction instruments decreases. When that Russian oligarch sells his shiftload of Bitcoins for US dollars, Bitcoin value goes down. When that happens -- when Bitcoin prices drop by 20 percent or more -- BUY! The price will inevitably come back up, I assure you.

When Bitcoin prices rise by 20 percent or more -- SELL! You just made 40 percent on your money.

Rinse, repeat, automate, get rich.

Nothing short of some other cryptocurrency taking the business from Bitcoin is going to change this trend. Say Goldman Sachs throws billions into doing exactly as I propose but as an institution. That will drive Bitcoin values generally higher and decrease price volatility a little, but the general trend will continue. So lower your threshold to +/- 10 percent (instead of 20) and do twice as many transactions.

The success of this strategy comes, I think, from the limited supply of Bitcoins. With only 16 million in circulation and only 21 million EVER, there will always be price changes with larger transactions, which is to say there will always be profit opportunities. I wonder if this was part of the Bitcoin plan from the beginning?

Another growing cryptocurrency is called Ripple and it was designed, frankly, to avoid these very profit opportunities. There are 100 billion Ripples, for example, compared to 16 million Bitcoins. But then Ripple is aimed straight at inter-bank transfers while Bitcoin has to be aimed, I’m guessing, straight at those who prefer to avoid banks altogether, at least for transactions like these. Bitcoin is the Wild West cryptocurrency.

Now for the paper test of my trading strategy. Using the interactive Bitcoin historical daily price chart at 99bitcoins.com, I started my paper test by converting $100 to Bitcoins on July 17, 2010 -- the first day Bitcoins were ever traded -- when the price was $0.05. I then scrubbed through the data looking for selling and buying opportunities that more or less met my +/- 20 percent guideline.

This is neither an optimal nor a perfect trading strategy and it misses a lot of profit opportunities, but is easy to automate. For example there are times when the sell signal is just a hiccough and the price keeps going right on up (or down), but I’ve already sold (or bought). In some instances there are almost daily trades while in two cases I went more than a year without doing anything because my criteria weren’t met. In all, there were 31 total transactions, with my last SELL order on February 2, 2017 at $990.65 for a total value of $21,638.88. A BUY order followed on March 26, 2017 and prices are generally higher since, but I’ll stand on growing $100 to $21,638.88 (almost a 220X profit) in about 6.5 years.

In contrast the S&P 500 grew by 2X (from 1100 to 2300) in the same period.

But maybe my huge Bitcoin paper trading success had to do with starting at the very beginning when a Bitcoin was worth only a nickel, which will never happen again. This is a mid- to long-range trading strategy I’m proposing, but if it has any real value that should be visible in a couple years, so I went back to the 99bitcoins chart and did the same analysis starting a year later, then two years, three years and four years later. I also did the analysis beginning when Bitcoin first hit $10, $100 and $1000.

Starting with $100 in July 2011 my paper trades grew to 1,056.26 in 5.5 years for a 10X return.

Starting with $100 in July 2012 my paper trades grew to 2,020.99 in 4.5 years for a 20X return.

Starting with $100 in July 2013 my paper trades grew to 289.81 in 3.5 years for just under a 3X return.

Starting with $100 in July 2014 my paper trades grew to 183.41 in 2.5 years for a 1.8X return.

Starting with $100 when Bitcoin first reached $10 in June, 2011 my paper trades grew to $1532.01 in 5.5 years for a 15X return.

Starting with $100 when Bitcoin first reached $100 in April, 2013 my paper trades grew to $505.82 in 3.75 years for a 5X return.

Starting with $100 when Bitcoin first reached $1000 in December, 2013 (a true moment of irrational market exuberance) my paper trades didn’t really grow at all in four years but at current prices I’d get my money back.

So in all scenarios except one, my paper returns clobbered the S&P 500 and in that one exception, though I didn’t make any money, I didn’t lose any, either, other than opportunity cost.

Since I’m known as an economics blogger of sorts (the Kauffman Foundation has declared me several times to be one of the top US economics bloggers), but I’ve never before proposed a trading strategy, I thought I’d reach out for some adult supervision. So I showed a draft of this column to Darrell Duffie, Dean Witter Professor of Finance at the Stanford Graduate School of Business and a friend of mine for 30+ years. Here’s what Darrell had to say more succinctly than I ever could:

"On the substance, you are proposing that there is mean reversion in the price of Bitcoin through the effect of price impacts caused by big transactions. This happens a lot in other financial instruments. I don’t know whether this is a correct diagnosis in the case of Bitcoin price behavior, but I would not rule it out. It seems reasonable."

Photo credit: Lightboxx / Shutterstock

© 1998-2017 BetaNews, Inc. All Rights Reserved. Privacy Policy.