How Investing In Bitcoin For The Faint of The Heart
I know that all my articles are on the topics of machine learning, software design, scalability, and infrastructure, so why did I change my topics? what happened did I lose my mind?
No, my dear reader, the thing is I like to trade and invest, and I like to do it in normal stocks and cryptocurrency, my idea is to take all these topics machine learning, software design, scalability, infrastructure, trading and investing as progenitor topics which need to interact between each other to build a new idea. Let’s jump and talk about investing in cryptocurrency, as you know crypto is volatile if you compare it with normal stocks and bonds, it’s not for the faint of the heart.
This is because Bitcoin the king of the cryptocurrency world have more or less 48 per cent of volatility per year at the time of writing this post, depending on which exchange you measure the volatility, so what’s volatility, what’s hedging and how we can invest in Bitcoin without fear. First, let’s talk about hedging and we need to mention who’s the first guy who used this technique and made a profit with it.
What is Hedging?
Suppose you’re a fan of Real Madrid and you decide to bet 99 Euros on them to win the next UEFA Champions League. The bet pays 999 Euros if you get it right. After couple of months later, Real Madrid made it to the final and is set to play against FC Barcelona. You feel that this game is going to be a difficult one and that the outcome is uncertain historically speaking. You don’t want to risk losing your entire 99 Euros, so you decide to hedge your bet by placing a new bet against Real Madrid, it’s feels hard to bet against your team, but you have to protect your money.
You bet 500 Euros that FC Barcelona will win the game. It pays an even 500 Euros if you get it right. Now, if Real Madrid wins, you end up with 598 Euros (the 1098 Euros minus the 500 Euros you lose on the new bet). If FC Barcelona wins, you end up with 500 Euros (from the new bet). With just the initial bet on Real Madrid, your options were either you make 0 Euros which means you lose everything or 1098 Euros, depending on the outcome of the game. But by using the second approach in which you mitigate your risk, your options are now either 500 Euros or 598 Euros.
No matter what happens, your expected win is 549 Euros which is 500 plus 598 divided by 2, assuming that the game is a toss-up. By hedging your bet, you’ve minimized the losses you’re taking and can better predict the amount of money you will end up with. This is a simple explanation in Feynam’s terms regarding hedging. After this beautiful explanation of the concept of hedging let’s move on and talk about the father of hedge funds.
The Big Daddy
Alfred Winslow Jones was described in the New York Magazine of 1968 essay as “big daddy”. Jones created two investment ideas that helped frame his portfolio. Jones developed equilibrium by going long in potential shares and short-selling in less promising shares, which means he borrowed and sold them, predicting that their value would decline. By being some stocks long and others short he protected his fund from market fluctuates.
After hedging out market risk in the way commented before, he felt secure in leveraging his bet with borrowed money. This formula of hedging and leverage had a miracle influence on Jones’s portfolio of stocks. The same strategy could be put in bonds, futures, options, swaps, and any combination of these financial instruments this was its true magic. We can say Jones built this formula by chance rather than by purpose, He pioneered a platform for complex strategies more than he could contemplate.
What is Bitcoin?
It’s just a list of names. Not only do their names appear, but so does their bank account amount. Not nearly the technological revolution you anticipated? Let’s take a moment to consider what makes this list so unique. But first, recognise that our current banking system is nothing more than a list of names and balances. Our society has already made the switch to digital currency. We know how much money we have depending on the balance in our bank account. Your bank does not truly have that exact amount of money in a vault somewhere; it is only a figure in its database.
What distinguishes this Bitcoin list? This list is available to everyone we know. Not only does the bank know how much money everyone has, but everyone who possesses a copy of the list does as well. Strange, isn’t it? Simply ask for a copy! Because everyone has access, the list is incredibly easy to discover. You’ll see below that Alice is willing to share her copy. Why is this shared list useful?
Let’s assume Bob and Dave go out to dinner one night, and Bob, as usual, forgets his wallet. Dave pays the bill. But now that we’re in the twenty-first century. Bob realises he has two options for repaying Dave. Dave owes Bob £19 for supper. Let’s look at how Bob would pay Dave.
Using a Bank: I’m sure you’ve heard of this approach. You tell your bank who you want to transfer money to and how much you want to send. The bank will rearrange the numbers in its database such that Bob now has £19 less and Dave has £19 more.
Using Bitcoin: There is no need for a bank while using Bitcoin. Remember, this is only a list, and Bob and Dave both have a copy. So Bob deducts £19 from the balance next to his name and adds £19 to the amount next to Dave’s name. Money was delivered without the use of an intermediary
What is Volatility?
Volatility in simple terms, is how fearful something is of going up or down. It’s a measurement of fear and uncertainty among investors. Sometimes prices of things (bonds, commodities, crypto, stocks) move big and quickly over a short period, and this movement can go down or up. You can measure volatility in both directions up or down.
The volatility of the crypto market is a measure of how much the entire value of the crypto market changes up and down. Individual cryptocurrencies, such as Bitcoin, might be deemed volatile in addition to the market as a whole. More specifically, volatility may be calculated by examining how much an asset’s price differs from its average price.
Standard deviation is a statistical measure of market volatility that measures how far prices diverge from the average price. If prices fluctuate inside a limited trading range, the standard deviation will be low, indicating little volatility. In contrast, if prices change rapidly up and down, the standard deviation returns a high result, indicating extreme volatility. You can see in the image below the higher volatility of Bitcoin in October 2021, with the volatility measured by the yellow line in the second portion of the graphic.
Hedging Techniques
In most cases, hedging tactics entail the use of financial products known as derivatives. Options and futures are two of the most used derivatives. You may use derivatives to create trading strategies in which a loss in one investment is compensated by a gain in another. First, we will talk about the futures contract, its definition, simple explanation, an example, and use cases of futures contracts. Second, we are going to dive into options, options are complex products and you need to read and learn about options as much as you can.
Futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. futures contracts are normally traded on an exchange. A simple explanation of the future is the following. Let’s imagine you have a car, and you want to sell it to your friend, but you can’t meet your friend right now, because both of you are living in different cities. So, you both agree to make a special agreement. You decide to sell the car to your friend at a fixed price, but the actual exchange will happen later when you meet. That special deal you made is like a futures contract.
For example, say you own an ice cream shop and you want to make sure that you always know how much you’ll pay for things like milk. You could buy a futures contract of milk from the CME group, which means you’re saying that no matter how expensive the milk gets, you’ll pay the price you agreed to in the contract on the agreed-upon date. That way, you know how much you’ll spend and you can plan accordingly. Is like insurance against the spike in the price of milk so you can protect yourself from this event.
There are two main strategies for the future:
The first technique is hedging and here you have two scenarios:
- When the price of the underlying asset goes up you need to take a short position against loss.
- When the price of the underlying asset goes down you need to take a long position against loss.
The second technique is speculation and here you have two scenarios:
- Long position makes money if the price of the underlying asset goes up, and loses money if the price of the underlying asset goes down
- Short position makes money if the price of the underlying asset goes down, and loses money if the price of the underlying asset goes up
Forward contracts are the same as Futures Contract but operate in Over Counter (OTC).
Options
Let’s start by talking about options in simple terms. first, we will introduce the definition, then we move on to the subject-specific vocabulary, use cases and last but not least how they work in the real economy. In this simple explanation, we are buying a car as our example, so an option is a contract that gives you the right but not the obligation to buy or sell a car in six months from the car’s dealer with the price of 20K British pounds, and you only pay 200 pounds for the contract. Building upon this easy example we introduce the terms to make you understand options.
Exercise price or Strike: This is the price of the underlying asset (the car), the price of buying or selling.
Premium: This is the cost of the contract, the money that you have to pay in exchange for this contract, is the price of the option.
Expiration date: This is the date on which you’ll buy or sell the car from the dealer, in this case, is six months.
Underlying asset: The car
Type: you have two types here, it can be Put which is selling the car to the dealer, or it can Call which is buying the car from the dealer.
There are two main use cases of options:
- The first use case is hedging your risk, imagine you have a cryptocurrency like Bitcoin and you want to protect this asset from losing, so you need to use the put option, if the asset decreases in value, the option increases in value.
- The second use case is speculation, your betting on the market going up or down by trading options.
How do options work?
There are two types of options, calls and puts, and for each type of option there are two scenarios short and long or (sell and buy):
Buying(long) a call option, gives you the right but not the obligation to buy the underlying asset (Bitcoin in our case) at the strict price (exercise price).
Buying(long) a put option gives you the right but not the obligation to sell the underlying asset (Bitcoin in our case) at the strict price (exercise price).
Let’s see a simple example:
- Calls: A call is the option to buy 100 shares of a stock at a defined price (called a strike) by the expiration date. A buyer of the call thinks the price of the stock is going to go up, and the seller thinks that it will stay below the strike price.
- Buyer of the Call: Pays a premium to the writer of the call. This premium ranges wildly depending on how volatile the stock is (basically what are the odds that a stock will move up from here). A stock like Coke or Proctor and Gamble have very low premiums because there is very little risk they’ll run up more than a few dollars a share. The buyer of the call would generally only “exercise” (use) the option if the share price of the stock goes above their strike price plus the premium. The goal of someone who is buying a call is that a stock moves up in price (hopefully well past the strike price)
- Writer (Seller) of the Call: Sells the right to the buyer to sell them the stock at the strike price anytime before its expiration and immediately receives the premium in their account. Their goal is to have the stock stay below the strike price. If it does, generally the buyer of the call will not exercise the call. The seller keeps the premium. For many investors, they write what are called “covered calls,” meaning they own the stock that they would be obligated to sell. A “naked call” is when you do not own the stock, and would have to go out, purchase the stock, and then sell it (likely at a lower price than you purchased it) if the option was exercised.
Thanks for reading. If you loved this article, feel free to hit that follow button so we can stay in touch.
