Here’s why Bitcoin and Crypto-currencies are most definitely, absolutely, a bubble waiting to burst

Ok, a confession. The headline is a pure hook but it also serves a purpose for the rest of the post, so I apologise but please indulge me. First, how many of you clicked the link because you were enticed by the title?

Hopefully the rest of the post will clarify why I have several problems with Crypto-currencies and believe it or not, they’re mostly nothing to do with the actual semantics of digital currencies.

Before I start let me just set my stall out clearly;

  • I’m not a sour puss because I wasn’t in at the bottom
  • I’m not some old fuddy duddy who doesn’t understand the digital world
  • I’m not railing against Crypto’s for kicks or clicks
  • I never believe all of the hype
  • I’m a long-time trader who takes the job of limiting my risk very seriously

I hope to highlight some key warnings for traders and investors that I think are important. That’s what I try to do with Forex, and I see crypto-currencies as no different.
I’ll start with the trading aspect first.

Why the technicals don’t work on Bitcoin…yet

Here’s my first contradiction. Technical analysis used properly is a method to try and define and mitigate your risk when trading. It never has, nor will it ever, tell you where a price is going. At best, all it does is provide a visible indicator, on a chart in an asset where the price might do something. Whether you’re looking at bat wings, Elliot waves or moving averages, it doesn’t matter. I could get a marker pen and physically draw a line over a chart showing on my pc screen and use it to trade from. If the price falls to the line, I might buy it on the line, with a stop just below. All I’ve done is ask the question about what the price will do when it gets to my line. If it holds I win, if it breaks I’ve lost but the key exercise has been to define my risk on that line. In that sense, you can use technical analysis on anything with a price, including crypto-currencies. But, here’s the crunch, technical analysis really only works as a self-fulfilling prophecy. Why should a price stop on one line or another? It works purely because of weight of numbers. If 50% of the trading world is watching the same 200 DMA, and they all trade the 200 DMA when the price gets there, all at the same time, that’s a hell of a lot of money entering the market to trade the same way. That’s the sole reason why technical analysis works. Nothing more, nothing less and it all boils down to simple liquidity.

Back to the point. The tech doesn’t work properly on crypto-currencies yet because there’s not enough people trading it. Sure, retail brokers are opening up CFD contracts left right and centre but the institutional money (banks, hedge funds, models, prop shops and the like) aren’t all trading it, and therefore they’re not trading it technically, nor providing the liquidity. You may see every Tom, Dick and Harriet producing charts for it but as per the point above, if there’s no real and sizeable money trading the tech levels, it’s not going to work as well.
That leads nicely on to my next point.

Liquidity

The reason main financial markets work is because of liquidity. The financial world is plugged into bonds, stocks, and forex. The “market” is all that liquidity being provided by central banks, big banks, institutions, businesses. All the way down the ladder there’s liquidity coming into the market. There is next to none of that institutional liquidity in crypto-currency. You can’t even short actual bitcoins properly in decent liquidity markets yet. Who stops bitcoin rising 1000 pips then falling 2000? Yes, there may be some big players in Bitcoin because someone is buying and selling enough to move the market but there’s nowhere near enough the real and genuine liquidity providers.

For trading, whether it’s Bitcoin via the physical, CFD’s or futures, it means there’s no big boys to keep the market in check. By and large we don’t even know who’s moving prices now so the risk of manipulation is huge. What that really means for us trading it is that there’s no controls, no buffers. Like them or loathe them, banks and financial institutions keep markets generally sound and well controlled. That level of market control is just not there yet. That doesn’t mean we can’t trade it but it just means the risks are exponential, and as traders we have to keep risk to a minimum.

What are the other problems facing crypto-currencies?

It’s still relatively difficult to hold and convert crypto-currencies to cash, and your investments are not covered by the regulators

If you know what you’re doing, realising coin holdings is pretty straight forward although it’s still a bit of effort. For our mate Joe Public, it’s not. If they can’t cash in their investment as simply as picking up the phone, sending an email, or walking into their bank, they’re going to panic if something does happen. They also have no regulatory cover, no government compensation schemes, and no recourse if they lose their digital wallets or they get hacked and stolen. Again, like them or loathe them, banks and regulators at least offer a few methods of protection, even if it’s like getting blood from a stone when you need to use them.

Most people don’t understand Bitcoin or how crypto-currencies work

I’m going to assume that most people in trading understand a digital currency. The possible benefits of not being tied to banks or institutions to make and receive payments around the globe etc. I’m no expert at all but I get the basics. However, the average person doesn’t. How many people will know that there’s only a finite number of Bitcoins that will be created?
There will only be a total issuance of 21 million Bitcoins. Currently there’s around 16.5-17 million, and an ever-increasing number of miners trying to get them. What do you think happens when we hit 21 million and no more can be mined? There are two possibilities.

  1. The price absolutely crashes as all those miners close up because there’s nothing left to mine, and therefore no more money to be made. Other investors deem it game over so they sell out too
  2. Bitcoin prices become very volatile because now there’s only a limited amount of an asset, it’s open to cornering and manipulation

In my view, option one is the most likely outcome. If you can’t mine for Bitcoin anymore, you’ll go and mine some other crypto-currency. The Fad will wear off for investors and BTC will get dumped.
There’s also one other potential sting in the tail as Bitcoin themselves highlight;

There’s also one other potential sting in the tail as Bitcoin themselves highlight;

“Bitcoin is unique in that only 21 million bitcoins will ever be created. However, this will never be a limitation because transactions can be denominated in smaller sub-units of a bitcoin, such as bits – there are 1,000,000 bits in 1 bitcoin. Bitcoins can be divided up to 8 decimal places (0.000 000 01) and potentially even smaller units if that is ever required in the future as the average transaction size decreases.”

In the FX world, that’s called devaluation, and a similar thing could happen in Bitcoin, reducing the value of coins and investments in an instant.

The tax man will want his pound of flesh

Coinbase has just lost a case in the US and now it will have to hand over identifying records for anyone who has bought, sold, paid or received over $20,000 through their accounts between 2013 & 2015. While crypto-currencies aren’t completely anonymous, keeping your name off the radar is fairly easy. Further expansion of tax offices digging into digital holders could cause coin holders to sell out of those under the spotlight.

Taxes still have to be paid on any realized (and unrealized investments) which could cause paper millionaires to sell up.

So why are crypto-currencies the next boom and bust asset?

We’re in the “New fad” phase

Go to Coinmarketcap.com and click “view all” on their crypto-currency list. After your pc browser has taken about 30 seconds to load them all, you’ll see there’s currently 1326 different cryptos. That’s like having 1326 different EURUSD markets. That’s not going to last. At some point here’s going to be a clear-out and that will be during the bust part of the cycle.

We’re also just starting to enter the “Frenzy phase”. This is part of the show where the average Joe Public starts jumping into Cryptos because he’s seeing crap rates on his savings and pensions, and all he he’s hearing about is how there’s millionaires being made every second in Bitcoin. Joe Public is always notoriously late to the party but when they jump in, that’s usually a big fat signal that we’re near the top. We’re not there yet but we’re heading there.

More and more of the press and publications, back page adverts both on and offline are switching from the usual diet fads and crappy household goods to how much we could all have made if we had invested in Bitcoin back in 2012, and how it’s not too late to do so now. Here’s two ads I got in quick succession from a mobile FX charting portal.

Bitcoin adverts

Bitcoin adverts

The sharks and charlatans are out and they’re going to suck a lot of money into less than solid products. Bitcoin at $11k takes all the headlines but it will be all those lesser known cryptos that will be peddled as the next Bitcoin. All those lesser offerings with cheaper prices will be more enticing to punters. Most folks haven’t got tens of thousands to buy a couple of Bitcoins with but they might have a few thousand to sink into a cheaper crypto being sold as the next $10k Bitcoin. Those minor crypto’s will be the first to go pop, the first instance big trouble hits Bitcoin and folks start losing money. Main street investors get scared quickly, especially when they invest money they really can’t afford to, and once the pack starts running, it often turns into a stampede.

So, if you get your parents or Great Aunt Maude asking you about Bitcoin, that’s the time to go short 😉

When will the bust come and how bad will it be?

The golden question. The answer is, we don’t know but we should be aware of the signs. As written above, the “Frenzy phase” is just starting so when that reaches extreme levels, when you can’t move for coin pushers, and stories, and everyone down the pub talking about it rather than the football, that’s when we’ll be close to the top.

There are so many similarities with the dot.com boom and bust it’s striking, yet people are all too quick to forget or ignore the lessons from that.

How bad the bust will be will depend on how much money is involved. It’s ok for the CME and Nasdaq to open exchanges to create safer and more open avenues for institutional money but that’s just adding a trading layer over the effective ‘cash market’. That doesn’t address the liquidity issues I raised above in that ‘cash market’ (Bitcoin itself). Futures markets will be following the Bitcoin price, not leading it because institutional money won’t be at work in the cash market. Investors on renowned exchanges like the CME will be just as susceptible to wild moves as everyone else, and any big trouble in Bitcoin will hit all investors no matter what vehicle they’re in. Yes, it might be more controlled by way of margins but that still won’t stop the futures price moving 2000 points if the underlying does.

Crypto-currencies are a dead man walking then?

Not at all but it is a boom and it needs to have its pop before it can properly become a safe and effective trading and investment market. The likely outcome is that something pops the bubble and we get a big correction. That’s likely to happen when those holding large amounts of Bitcoin or profits decide that they can’t resist the high prices it’s hitting. It only takes a couple of big players to sell up and the world will declare a top and the sheeple will follow. Look at the crash from the 11k+ highs to 9k Nov 29th. That supposedly happened because of a large profit take trade, just one.

When the bust happens, people and businesses will get burnt, trust will be lost and crypto’s will have to start all over again. Like the dot.com boom only the strongest will survive (think again about the 1326 crypto’s in play), and the rest will become road kill. That’s when the regulators will step in and take crypto’s under their wing and the real long-term prospects of crypto’s will potentially be sounder. It always happens after people get hurt.

In effect it will be like any other typical market correction but just on a much grander, crash type scale.

To summarise my thoughts;

  • I’m not against crypto currencies and all they stand for
  • I’m wary about trading it because it’s a wild horse and there’s too much risk
  • It’s not fully ready to be traded technically yet, and considering 95% of retail traders rely on TA, that’s very dangerous
  • It’s starting to show all the bubble signs of sucking in investors who don’t understand what they’re getting into
  • It’s just not a safe enough asset

Really, it all boils down to risk. If I think risk is too high in any trade, I don’t make that trade. Crypto-currency risk is off the charts and I don’t need a market with 2000 pip swings in my life. There’s no crying over missing the boat, and there’s plenty of other trading opportunities in this game. If you feel like you’re getting sucked into trading crypto’s because of all the instant millionaires you’ve heard about, that’s your first clue that you’re not following your risk discipline, and that you need to be wary. When I speak to people who struggle to trade FX day to day, suddenly going on about trading Bitcoin, I’m close to facepalming. Trading is all about risk and the lower you can define it, the safer you’ll be.

Let the furore die down and wait until it becomes a proper market to trade and not the Wild West.

Trade safe folks.

Ryan Littlestone

Psychedelic chartist extraordinaire. Have your shades ready.
Philosophy: “Don’t be a Dick for a tick”

Read how Ryan got into trading here
Ryan Littlestone

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