Building core competency for Cryptocurrency trading

Bitcoin
May 14, 2017

People who have jumped onto the bitcoin bandwagon in India seem to have come in all for one but single purpose, making money. Most think of it as a quick money making scheme while some have become so called “guides” to comment on the price forecast of BTC/INR front. Making money surely is a good intent. In fact I strongly believe in the words of Gordon Gekko (Wall Street) that “Greed is Good”. When the price movement on a graph looks like this:

it sure is going to be feeding frenzy! Everyone is awestruck, in panic, and the feeling of FOMO seethes in. In a nascent industry where there has been no credible source to follow as to what probable reasons can be attributed to the volatility of BTC/INR, people tend to make their own assumptions (read: speculation) basis the experience (depth and length varies from person to person) they’ve had with their traditional investment products such as foreign exchange, mutual funds, trading in stocks and holding precious metals over time.

While the traditional modes of investments as mentioned above have a certain degree of familiarity with most of the people (they still tend to make big mistakes there), they tend to make the mistake with Bitcoins by putting it in the same frame of reference. To predict benefits in forex one might do a PESTLE (Political, Legal, Economic, Social, Technological, Legal and Environmental) analysis around the currency concerned, a serious investor in equities/stocks might follow the RoCE (Return on Capital Employed) of the company, etc. But such signs are exhibited by due diligence of experts.

The simplest thing which people tend to do is follow the line chart of previous historical performance of the financial instrument which is entirely short sighted (in the words of terms of conditions of all mutual funds schemes) as  “past performance does not guarantee future returns”. In vain, people tend to follow what is reported in the news. Recently, people are predicting Bitcoin’s price basis the acceptability (or not) in some of the countries. Which again is entirely wrong.

Reminding people again what Bitcoin is. Bitcoin is digital money, but it’s so much more than that. Saying bitcoin is digital money is like saying the internet is a fancy telephone. It’s like saying that the internet is all about email. Money is just the first application. Bitcoin is a technology, it is a currency, and it is an international network of payments and exchange that is completely decentralized. It doesn’t rely on banks (I am sure this must be a shocker for many). It doesn’t rely on governments (doesn’t sound exciting right). Having said that, understanding Bitcoin and alternate cryptocurrencies are not everyone’s cup of tea.

“If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter” – Warren Buffett

Given the tripling of the cryptocurrency market cap in the last few months and the 3- to 10-fold increases in virtually every major altcoin, cryptocurrencies like Ethereum and of course Bitcoin have been getting a stunning amount of attention in the media lately. It’s also a frustrating time for many long term bitcoiners and crypto fans, because we’re faced with a barrage of questions from outsiders who see the returns and want to buy in to the “next big thing” and make a quick buck.  It had to happen as the market cap of Bitcoin is hovering around $30 Billion right now and Bitcoin is the only base crypto to trade in other currency (except Ethereum and Litecoin). And when markets are at peak, everyone is a genius in a rising market.

Something to realize first of all is that the crypto market is heterogeneous. It has straightforward cryptocurrencies (bitcoin, litecoin, dash, monero), smart-contract cryptos (ethereum, ethereum classic) and a whole bunch of crypto tokens that follow dedicated platforms (golem, augur, steem). Not mentioned are ripple and stellar because they aren’t really cryptocurrencies at all.

The investing theses for all of these categories is radically different. The measure of success for a currency or store of value is adoption, merchant use, low volatility, a large network, and real world acceptance as something worth owning. Bitcoin has this right now, which is why it’s more than 50% of the ecosystem, and none of its competitors are even close. Monero, Zcash, and Dash are a special case in that they try and make transactions anonymous and privacy, allowing for use cases on the darknet markets, for instance.

Taking the above as a general introduction to cryptocurrencies (a detailed article to follow soon). The first thing to mention is that passive investing in crypto has historically been a terrible strategy. Just buying bitcoin almost always outperformed. This was due to the poor set of altcoins, and the size of bitcoin’s almost insurmountable network effect. This sort of changed in March and April when bitcoin’s dominance went from 80% to ~50%, and it remains to be seen if this will persist or not. But the point is, buying the index is usually an awful strategy in crypto, particularly because there are so many truly awful projects out there.

So what does it take to invest responsibly in cryptocurrencies? It requires at least a basic understanding of three disciplines: public-private key cryptography; programming, and how open-source projects function; and economics, particularly game theory and the quantity theory of money. This is why it is so difficult to apprehend easily: because very few people actually boast a sincere understanding of these three topics.

You need to be able to determine whether the tech is actually going anywhere, and whether the task the developers have set themselves is possible or realistic. You need to know how open source networks are governed, and which models strike the best balance between efficiency of decision-making and fair consensus. You need to be able to measure the inflation schedule of the cryptocurrency, and see whether your coins are going to inflated away. You need to be able to make plausible guesses about the potential market for the crypto and estimate future values. Note that the payoff structure is not equity-like. It’s more like early stage venture capital, or buying loss-making biotech companies. Here’s my checklist of questions to answer, ordered by importance:

  • Does the project offer a significant improvement over its nearest competitor, or a reasonable chance of success in its stated aim? Is there a demand for this project? Does it have a concise and reasonable goal? (Narrower goal: higher likelihood of success).
  • Is the development team competent? Are they committed to the coin? What’s their track record? Is is an active dev team? Do they have a roadmap for the future? Are they transparent about goals?
  • How is the development team funded? Is the currency corporate-backed? Is the funding transparent? Was the coin significantly premined? (Usually bad) Are developers paid via iterative community project crowdfunding? (Usually good).
  • What is the governance structure of the currency? Who holds ultimate control over decisionmaking? How are decisions made? Are they transparent? Are mining/developer incentives aligned?
  • Does the asset have acceptance and use today? Does it have a functioning use case? If it doesn’t, does it have a decent chance of being accepted?
  • Has the asset’s “market cap” tripled or quintupled in the last few months? Was this based on any fundamental changes (new software releases, etc) or just speculation?
  • What are the transaction volumes like? (Hint: divide market cap by monthly averaged daily on-chain tx volume to find a consistent ratio) What’s the ratio of on-chain transaction versus exchange speculation? Has price gone up independent of transaction volumes?
  • How long has the asset been around? Think of the Lindy effect. Older is usually better.
  • What’s the community like? Is there censorship? Does it have an active subreddit? Do the developers answer questions? Are they accessible? How big is the github community? (Hint: you can divide market cap by github commits to find a comparable ratio).
  • Are you psychologically able to hold this coin in a 90% downturn? Is this a high conviction thesis or are you betting on being able to sell it to a greater fool?

Cryptos are an asset class that is both radically different from anything that has existed before. They are also incredibly heterogeneous, as I argued above. It also leads to cultism – so bitcoiners generally take a dim view of Ethereum, and vice versa. Monero fans generally don’t like dash, and so on. You have to keep your mind open to understand new opportunities as they arise, and to stop yourself becoming too mentally invested in your project of choice. The vast majority of projects will fail within 5 years, so becoming overly certain of the success of one will probably devastate you. If you can stay balanced, stay honest about your crypto’s chances of success and adoption, not get tunnel vision, and not take overly risky positions, you have a good chance of not losing everything. Remember the payoff structure. Heavily rightward skewed. A ton of cryptos earn no return and a select few earn an absurd (1,000-10,000x) return.

My circle of competence doesn’t extend to traditional financial products and hence I don’t touch those. I have a mixed bag of mutual funds and fixed deposits and I usually receive an average return of 15% p.a. I went into the crypto rigorously from all angles, be it white papers, reddit, trading candles, reading about the founders and development team of new coins, actively trading in almost ten crypto’s daily, following experts like Andreas Antonopolous (make sure to read his two books: The Internet of Money and Mastering Bitcoins), Vinny Ligham, Roger Ver,  and reading every book published on Bitcoin and Blockchain.

I know everyone is in a hurry. FOMO and YOLO plagued the generation we are. Make your decisions wisely by thinking through all the details after you have checked all the necessary facts. And for that my friend you need to be a voracious reader, where the superlative term of “voracious” is just an understatement.

(Acknowledgement: thanks so much for the reddit user isrly_eder for his recent article on the same topic)

2 thoughts on “Building core competency for Cryptocurrency trading”

  1. Saransh says:

    Poweful article.

  2. Saurabh says:

    Indeed a good read!!

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