EV Quants
The Dangers of Bitcoin’s Pump EV Quants

On 25 October 2019, Bitcoin was pumped (intentional choice of words) by 43.4% within 24 hours. This was the second-largest move in Bitcoin’s history and seemingly represents an incredibly positive event for crypto investors (a 43.4% price increase!). Yet, after considering its implications, there is nothing positive to be found.

This post highlights our take on the recent price action and acknowledges some cases that are likely to be threatening to the long-term viability of the crypto industry (and Bitcoin traders, specifically).

What Happened

This recent move was basically a coordinated short-squeeze, which in itself isn’t unheard of — especially in cryptoland. The concerning thing, however, is that after an initial squeeze, market makers pushed the price for another leg-up, going into five figures with an even more aggressive short squeeze — totaling a 43.4% move.

Approximately $400 million USD in positions got liquidated on Bitmex, which surely has presented “them” a nice way to exit their positions or open some new ones (shorting against the now bullish-minded market). We will see this playing out in the next couple weeks.

We think this move was incredibly harmful for the industry, especially since the general trend in crypto seemed to be moving towards maturity and adoption. Apparently, as this price action shows, it is still very far from it — and not necessarily moving into the right direction.

More Harm Than Good

With time, assets mature, and volatility naturally drops. Volatility drops because more participants provide liquidity. In crypto, Bitmex has the monopoly for liquidity (let’s be honest, it’s impossible to compete with their internal market making using the public APIs). As such, liquidity, volatility, and basically Bitcoin’s future in terms of price, lies in the hands of a very concentrated group of actors with questionable motives.

If a 43.4% move like this can happen as easily as it did (there weren’t that many shorts open, judging by the open interest), the coming years of Bitcoin trading (luckily not blockchain!) are looking to remain nothing other than speculative.

The current situation, with a low amount of actors on highly leveraged exchanges, makes things appear like a big playground for market makers, who can push price around to meet their short-term objectives, liquidating positions worth millions of USD, mostly thanks to naive retail traders.

Everything described above only adds weight to the “speculative asset” hypothesis, and seemingly, Bitmex is only confirming this hypothesis by performing such short-term oriented stunts, favoring quick financial gain over real long-term growth of the industry. Institutional capital likely will be repelled by all this, if they are not already. Arguably, it is in Bitmex’s best interest to retain monopoly status and keep the space filled with retail traders for as long as possible.

Classical shitcoin chart. Will Bitcoin end up just like this?

Following the continuously declining demand for Bitcoin trading after the 2017 peak, Bitmex market makers have only a few ways left to sustain historical profitability — fueling artificial pumps from 3k to 14k to simulate demand — or simply treating Bitcoin like a shitcoin. We are afraid that another wave of “naive” retail traders will jump in to provide Bitmex with more accessible profits, and measures taken by Bitmex to “create” profit will become highly alarming. The crypto trading world will become more aggressive (and volatile) in the coming years, and this may have been the warning shot.

We are now, more than ever, including the possibility of an intentional flash crash (a 100% move?) or, even worse, some orchestrated exchange hack. We are moving 80% of our capital out of crypto (especially away from exchanges), even though we capitalized nicely on this move and the volatility. However, it remains just a matter of probability until something unexpected happens, and we believe such things will happen rather sooner than later.

Considerations for Traders

Traders should reconsider their strategies, mostly when it comes to risk management and to position sizing with effect on correct usage of leverage.

Risk sharply increased, and leverage/position size ideally needs to be adjusted (we leave it for another post how exactly to calculate risk, how to estimate a probability distribution for the long tail of returns, and how to enter positions while avoiding risk of ruin).

Leverage should be used according to predetermined factors (Kelly criterion, optimal f), rather than unconsciously, but, more importantly, it should be used to reduce exchange “counter-party” risk. Leverage allows traders to keep less funds on exchanges while retaining the same positions as bet sizing justifies.

What exact leverage is applicable depends on the trader’s available capital, objective, strategy, diversification, and so on. However, it is possible to get a good idea of what leverage to apply by using common sense and quantifying the risks.

For swing traders who use above 2.3x leverage, moves like the recent one would have liquidated their positions. This means leverage should be adjusted to the probability of such moves (which are challengingly hard to calculate mathematically, since returns don’t follow a normal distribution, and black swan events are not so rare in reality).

Accounting for 50% moves in general — even if these realistically happen only every few years, due to true black swan events and not coordinated pumps — is a good rule of thumb to approximate leverage. It is unwise to use anything more than 2x leverage, and instead work on increasing the trade frequency (using a quantitive approach? We do!). Ultimately, it doesn’t come as a surprise that one of the world’s best known investors, Warren Buffett, used an average leverage of 1.6x over the past several decades.

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