Bitcoin for Traders
'Bitcoin for Traders’ is a comprehensive guide to the world's first Cryptocurrency from an analyst’s point of view.
What exactly Bitcoin is, is very hard to define adequately, simply because it represents so many different things to different people. For some, Bitcoin represents an outstanding feat of creative thinking and programming. For others, it represents a social experiment on a global scale, which has the potential to disrupt almost every facet of modern-day life. For yet another group, Bitcoin is an alternative, secure and anonymous payment method that bypasses the traditional banking system. Then there are those who see the technology behind it as being unprecedented in its potential.
History of Bitcoin
Bitcoin was created by Satoshi Nakamoto – a name that is presumed to be a pseudonym for an unknown person or persons. Nakamoto has never revealed his, her or their true identity(ies) since introducing the world to Bitcoin in October 2008 via a paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System”.
Four months later in January 2009, Nakamoto released open source software to allow the Bitcoin idea to be implemented. The software was made freely available to facilitate the peer-to-peer aspects of the project. Nakamoto was not entirely altruistic. Having mined the initial or Genesis Bitcoin block of 50 coins, Nakamoto is believed to have then mined a significant number of Bitcoin for “himself” before his avatar disappeared.
Whether we will ever discover Nakamoto's true identity is an open question. But what is clear is that “his” ingenuity is going to have an increasingly significant effect on our lives. Certain aspects of that ingenuity will likely become pervasive, in the same way that smartphones have over the last decade.
The Blockchain is what is known as a distributed ledger.The ledger or record of transactions are kept and updated simultaneously, by all the participants in the network or group. For an entry to be recorded into the ledger, all participants or nodes must verify and agree on the details of that transaction. What's more, the Blockchain ledger cannot be altered or amended after the event. The exception being a fork in the underlying source code that was used to correct a programming error discovered early on in the Blockchains life.
As Bitcoin has become more widely adopted, the number of nodes in the network has also grown. That's happened for two reasons:
- To access actual Bitcoins, it was necessary to become a miner. Mining is the process where new Bitcoin are found or earned. Quite simply you mine Bitcoin by becoming part of the Bitcoin Blockchain or if you prefer, by becoming a node in the distributed ledger network. The more transactions that you verify, the closer you come to receiving or discovering your reward.
- You can buy Bitcoins on a Bitcoin exchange or accept them as a method of payment for goods or services if you didn't want to go through the effort of mining coins for yourself. Either way, your transactions will need to be verified and agreed by the whole network.
Adding a new block to the Blockchain requires verifying groups of newly broadcast Bitcoin transactions, which earns the miner a “coinbase”. A special transaction on the ledger that rewards the miner with newly mined Bitcoin. That is, provided the miner can also demonstrate a so called “proof of work”. To do that the miner must unearth what is known as a nonce - a number that is easily verified by the rest of the network but is extremely difficult to generate. The nonce itself is a random number that, when combined with metadata from the most recently processed block of Bitcoin transactions, creates a hash value or string similar to the one below.
In an ingenious but almost devilish twist, the more Bitcoins are mined, the lower the rewards that are available. At the same time, there’s a larger amount of work (computer processing power and time) needed to generate the nonce and earn that reward.
Did You Know?
According to data retrieved from the Blockchain in March 2015, between the 1st of March 2014 to March 2015, the number of calculations that were required to generate a nonce on the Bitcoin Blockchain went from 1.4 quintillions to 200.5 quintillion calculations.
As of July 6th 2017 that number stood at almost 712,000,000,000,000,000,000 calculations and rising.
Note: A Quintillion is a “1” followed by 18 zeros.
Think of your favourite double act. It might be Laurel and Hardy, Woody and Buzz Lightyear or perhaps Batman and Robin. Whoever you think of and however closely associated they are with each other, they are not as closely linked as Bitcoin and the Blockchain.
The relationship between Bitcoin and the Blockchain is symbiotic but not symmetrical. What we mean here is that the Blockchain can and does exist without Bitcoin but not the other way around. That's because the Blockchain technology has in effect been cloned to create other distributed ledgers. Some of these clones have been created to support different cryptocurrencies and other tokens. But there are others that are being repurposed to provide the backbone to and settlement for financial transactions and record keeping in markets as diverse as swaps and insurance. A “blue sky” research department at one of the world's largest banks (HSBC) has suggested that Blockchain could play a role in future monetary policy. By recording and verifying levels of consumer activity and if required to distribute funds (so called helicopter money) pro rata, directly to the points at which it would create the greatest economic stimulus.
A blockchain can also be used in combination with what is known as ‘Smart Contracts’ - an intelligent software that recognises when work is done and when payment required. It also facilitates and enforces the terms and obligations within the contracts.
A further innovation is the concept of “Rails” effectively a “straight line” of information that runs through your life from birth to death. It provides instant identification, medical and financial records or details of your spending patterns and preferences. All of which will be encrypted and invisible to the world at large, but at the same time be instantly verifiable via a blockchain to those entities with whom we interact in daily life. Rails and Smart Contracts are not yet at large, but they and other innovations will be with us sooner than we think.
In recent months these issues were put front and centre as the Bitcoin mining and development communities which debated the best way to increase the processing capabilities of the blockchain. There were two distinct schools of thought on how to achieve this and not much common ground between the two factions. In the end, the two groups decided to part company and to fork the Bitcoin code to create a new crypto currency Bitcoin cash. There had been fears that this hard fork would be detrimental to the Bitcoin price. But in fact, it’s turned out to have had the opposite effect, by removing uncertainty about the future of the cryptocurrency. As a result, Bitcoin has risen to new highs post the event.
Earlier we mentioned that the more Bitcoins that are mined, the more work that is required to unearth the next cache and that the amount of work required is rising, if not exponentially then at a parabolic rate. However, in a further nuance to the Bitcoin program there is a predefined and finite amount of Bitcoins that can be created or mined. That number is 21 million coins. Under current conditions, that limit is likely to be reached in a little over 20 years.
A sudden jump in the processing power of high-end computer chips or a sharp fall in the costs of deployment of existing technologies could hasten that process. Right now there are approximately 16.55 million Bitcoins in circulation. So we are just over three-quarters of the way through the mining process. But remember the difficulty in mining coins increases dramatically as more are discovered hence the long tail out to the year 2040.
Now just consider what we have just said. Unlike so called fiat or paper currencies or even physical commodities such as Gold, Bitcoin has a finite supply and more than 76% of the coins that will exist, do so already. As we have seen in recent years, paper currencies can be printed with impunity by central banks. The total amount of Gold traded in the London bullion market in a single year is almost ten times larger than the amount of Gold that has ever been produced. How is that possible? It’s possible because banks and others have created so called paper gold the equivalent of central bank currency printing in the commodity markets.
Though this might sound like a contradiction Bitcoin is the electronic equivalent of a physical market. In that, the whole Blockchain must have sight of and verify each Bitcoin transaction. Delivery of the underlying has to be made for every transaction, whether that is from buyer to seller or seller to buyer, customer to the merchant or from the coin base to a miner.
Now consider the demand side of the equation. The first recorded use of Bitcoin for a retail transaction was for the purchase of two takeaway pizzas. For which 10,000 Bitcoin (then valued at around $50.00) was sent in exchange for the placement of the pizza order on the credit card of a volunteer based in the UK. Today these would be the most expensive pizzas in the world. That's because 10,000 Bitcoin has a value, at the time of writing, of US$41,740,000.
Alongside the dramatic rise in the price of Bitcoin, the level of demand for the crypto currency is rising steadily. While we couldn’t yet say, it has been adopted as a mainstream method of payment. It is accepted by blue chip corporates such as Dell Inc and Bloomberg. What’s more, recent developments in Japan including the removal of an 8% purchase tax on the use of Bitcoin have created the potential for the country's army of retailers to start accepting payment in the alternative currency. Korea may adopt a similar policy to Japan and other Asian markets are being eyed as well.
Remember that to own physical Bitcoin you need to mine or buy them. Most consumers will not have the resources required to mine the coins and so will have plump for the latter option if they want to use Bitcoin as store of value or as a method of payment. However, Bitcoins can be shaved or broken into fractions of a Bitcoin which can be used to make even a low-value purchase or payment.
Let us take a closer look at the history of Bitcoin as far as price and volatility are concerned. For the earlier part of its life, Bitcoin had relatively pedestrian price action. By early January 2013, the price was just a little over US $13.00 per coin. But just three months later in early April, it had risen more than tenfold to US$143.00.
Just ahead of Thanksgiving 2013 it had rallied to a little over US$ 945.00 per coin.That figure was a medium term top, and the price declined steadily from there to around $225.00 by late August 2015. Almost exactly a year later, the price took off once more. Rallying from US$580.00 to trade at US$3422 in August 2017. By mid-September this year, the price had been as high as US$4950 before correcting to around US$4170.
Sourced from coindesk.
One of the objections expressed about Bitcoin is the level of volatility in the cryptocurrency, which has been labelled as extreme. It is true that Bitcoin is much more volatile than many other assets or asset classes. But these traditional asset classes have been continuously drained of volatility by the effects of years of QE or Quantitative easing.
After all, if there is a “permanent” open ended buyer in the room, then sharp downside moves (which tend to propagate volatility) are likely to be limited.
The diagram below shows an example of this type of upward momentum and trend confirmation.
“A sample with a high standard deviation is more spread out—it has more variability, and a sample with a low standard deviation clusters more tightly around the mean.”
The chart below plots Bitcoin volatility from mid-2010 into early July 2017 and expresses this as a number of standard deviations (think of this as a measurement of units of movement away from the mean or average). As we can see back in 2011, Bitcoin volatility reached as high as 15 standard deviations - an insanely high number. But since then, the level of volatility has been reducing. Yes, there were spikes higher in 2013 and again in 2014. But they were relatively short lived, and the trend has been moving lower since then.
Source: Bitcoin Worldwide
However, as we have already noted, a series of lower lows and lower highs also constitutes a downtrend. So while the Swing Trader may have seen a false breakout on the upside, the new lower low could identify the start of a new downside trend. Confirmation of this trend could come in the form of the price actions failure to trade above the new lower high, that was associated with the counter trend low. Followed by the print of a subsequent and new, lower low.
In July 2017 Bitcoin volatility was around five standard deviations. Now that's still a number that would make a risk manager blush. But it is a lot smaller than 15. To be clear a five standard deviation event should occur once in every 3.5 million results, under a normal distribution. Taking that into account, it’s clear that Bitcoin volatility does not currently have a normal distribution.
The reason behind this volatility is the fact that Bitcoin is not directly linked to any of the world's traditional financial structures. Be that nation states central banks, money transmission mechanisms or exchanges.
Ironically for an innovation that relies on networks for its very existence, there is no direct connectivity with other markets and therefore has little opportunity to hedge or arbitrage that volatility away. Instead, it's all internalised. There aren’t any models or valuation metrics for Bitcoin (though as we shall see some may now be emerging) which means that price is determined primarily by sentiment and the direction of the next order. Now that's a potent mix, but it is one that can create exciting opportunities for traders. However, they will need to be on top of their risk and money management game.
Since Bitcoin exists independently from the traditional monetary infrastructure, determining a valuation method for the cryptocurrency has proven to be difficult. In some sense, Bitcoin has no intrinsic value or perhaps even a negative one, given the amount of work and equipment now required to mine them. However, the fact that so many individuals or groups have taken the time to become miners and join the Blockchain offsets, commercial or mainstream demand for Bitcoin is increasing. A comparison has often been made with Gold, a more traditional store of value and means of payment. Of course, Gold is fully integrated into monetary and financial markets. For example, many central banks count bullion or gold bars among their foreign exchange reserves. From this standpoint, the comparison may not be that helpful.
New methodologies have sprung up alongside the emergence of other crypto currencies and the ratio in price between Bitcoin and these other tokens. However, Bitcoin is much larger and more established in terms of its market cap and longevity compared to other tokens.
So again I see this as being of limited use. In fact, in February 2017 the Signal Plot blog (a site run by a former Bridgewater Associates analyst) concluded that Bitcoin was unique and essentially uncorrelated to other traditional asset classes given what we know about the token.
Of course, there is one common factor between Bitcoin and other assets and that is the investor or trader. While in its formative days there may not have been much overlap between the hacktivist early adopters and financial traders, the two groups are now coalescing.
Original Bitcoiners are becoming aware of the financial implications and opportunities of ownership while financial traders have come to realise that there is money to be made in the cryptocurrencies.
In recent months new possible valuation methods have been proposed. One suggestion is that Bitcoin may have a relationship to the performance of the chip manufacturers whose products (particularly high-end chips and GPUs) are used by miners to unearth new coins. Remember the intense level of calculations required to generate a Blockchain nonce and provide proof of work to earn or uncover Bitcoins. Given that relationship, it's tempting to think that there might be something in this suggestion.
The chart below (source tradingview.com) plots the Philadelphia SOX or Semiconductor index against the EOD Bitcoin index over the last year.
There does seem to be some directional confluence between the two lines. But whether this is coincidental or more deep rooted is yet to be determined. It's certainly something that will be watched and give consideration to when trying to determine future price trends in Bitcoin.
As we have established, mining for Bitcoins can be a complicated and potentially expensive business. Even purchasing the tokens and storing them safely presents its own issues. I am sure we have all heard stories of people who have wiped or thrown away hard drives only to discover that this was where their Bitcoin and encryption keys resided. Issues around the safe storage of this data are probably the Achilles heel of the whole Bitcoin project.
But of course, if you are not directly interested in ownership of the underlying asset then you could consider trading in a CFD or Contract For Difference. This allows a trader to participate in the economic benefits of ownership, that is the change or rise and fall in the price of the underlying asset without the need for ownership of the same. Here at Pepperstone, we are pleased to say we have introduced such a contract. Clients can now trade long or short in Bitcoin through the familiarity and convenience of their MT4 terminal with the all of the associated charting functionality.
Additional Cryptocurrency details can be found on our website.
Ten Bitcoin Takeaways
- Bitcoin is a highly innovative attempt to create a new currency, asset class or store of value, or indeed a combination of all three.
- All transactions in the Cryptocurrency must be confirmed by the active nodes in the Bitcoin Blockchain before being added to the ledger.
- As new blocks of transactions are confirmed, miners have the opportunity to earn new Bitcoins as a reward. However, they must also have calculated the nonce value for that particular block and have that value verified by the Blockchain before getting paid.
- There is a finite limit to the number of Bitcoins which can be mined. The total number is 21 million coins. So far in Bitcoin’s eight-year history, 76% of these coins have been unearthed.
- It may take another twenty years plus before the final coins are mined due to the increasing complexity involved in deriving the nonces.
- Bitcoin's valuation has risen sharply since the cryptocurrency was introduced, rising by more than 300 times in the period between January 2013 to September 2017.
- Bitcoin appears to be uncorrelated to traditional asset classes, although the search for a comparative valuation method continues.
- Because of this non-correlation and Bitcoin's independence from traditional financial networks, its price is largely driven by sentiment.
- As a result, Bitcoin's volatility is internalised and not arbitraged or hedged away, as is often the case in other markets.
- Pepperstone customers can trade Bitcoin as a CFD priced in US Dollars per coin, allowing them to trade long or short positions with ease, on a familiar platform as and when they require.
Important: Cryptocurrencies such as Bitcoin are much more volatile than traditional currencies. Please ensure that you fully understand the risks involved before trading Bitcoin CFDs as you could lose substantially more than your initial investment if the market moves against you.
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