Investing in Cryptocoin vs Trading in Cryptocoin

Published: September 19, 2017 at 10:33 am

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Suppose you wish to “put” some money in cryptocurrency (or cryptocoins), say Bitcoin, altcoin, litecoin, fartcoin etc. would you trade or would you invest? It is obvious that due to poor liquidity, the crypto market is volatile. So instinct would tell us caution is necessary. So trading (frequent buying and selling) with regular profit booking seems like an obvious choice to make some quick money rather than investing (buy and hold with periodic investing).  In this post, I discuss the fundamental difference between the currency market and capital markets and if something can be discerned about cryptocoin risks.

The post is a simplified digest of my learnings from “Fractal Market Analysis: applying chaos theory to investments and economics” by Edgar E. Peters, one of the Five Books That Will Redefine Your Understanding of Stock Markets.

This is not a recommendation to invest or trade in cryptocoin and merely my attempt as a student to market risk to understand where they fit in the risk-reward map. This post is meant for those who have decided to buy cryoptocoins.

If you are new to this area, you could consider having a look at : Bitcoin: Should we use it as a currency or as an investment?

If you undecided, you can consider, Three Reasons to avoid Bitcoin or any other cryptocurrency

Cryptocurrency is a new kid on the block and trying to bin it in established classifications can be a big mistake. I will not take anyone who says they understand cryptocoin market volatility seriously. There is simply not enough data to make any meaningful observation.

However, there is enough data to understand the difference between, stocks, bonds, gold and conventional currencies. The question is, can we try to understand where cryptocoins fit in.

The idea is to find out if we can back our intuition or commonsense (to trade in cryptocoins) with some data based proof. The reason being, intuition can be wrong (eg. timing the market) just as often as it is right.

Now, the analysis presented in “Fractal Market Hypothesis” is extremely heavy. So I am going to keep it non-technical and represent the key results with a sketch.

Equity vs Bonds vs Gold vs currency (conventional)

The fundamental difference between the currency market and the capital market ( equity, bonds) is that in the capital market, there are actually securities being exchanged.

Equity and bonds have intrinsic value and they are exchanged for raising capital (funding an enterprise).

Currency (paper money) has no intrinsic value and need not be directly related to the growth of the economy. The central bank of a country has the power to manipulate its value (as measured against another currency) and its supply via interest rates or trading large quantities or more extreme and rare measures such as printing new money and ahem invalidating old ones.

Currency trading offers support to capital markets. Established market participants will readily recognise that currency market is a trading market.

As an economy grows, it impacts the return from the capital markets (equity and bond markets) and is correlated to economic cycles. Currency markets are not.

These key ideas which are well known should be seen in plot of risk vs investment duration.  Peters shows that this is indeed the case.  Here is a schematic (drawn by me) of his results.

The currency here is conventional currency and not cryotocoins.

Equity and bonds (capital markets) behave similarly. The risk over the long term is lower than the short term and it is range bound. That is the max risk and min risk are within a range (that cannot be predicted). Equities and bonds move within these bounds over the long term. That is there is reversionNOT mean reversion as there is NO mean.

The point is, buying and holding bonds and equity is less risky than trading in equities and bonds.

In the case of conventional currency, trading in currency has a risk similar to trading in equity and bonds. However, investing in currency is just as risky as trading in currency. In fact the risk of buying and holding currency is higher than trading in currency.

Before we consider cyrptocoins, a note about gold. Gold does not behave like conventional currencies. However, it also does not behave like equities and bonds and falls somewhere in between. In other words, it is debatable if gold has intrinsic value or not.

Cryptocurrency vs conventional currency

Cryptocurrency cannot be manipulated as easily as conventional currency, thanks to decentralization.  So it will not be linked to any particular regional economy and therefore not be linked to economic cycles. In this aspect, all currencies are the same. And if we go by this alone, our intuition is right and trading crypto is “safer” than investing in crypto.

However, cryptocoins are currently being mined (well, should I say, should be mined to ensure decentralization) and normal currency has no such (current) necessity. This means, the market forces and trading volumes are very different. This offers a possibility of investing in crypto.

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The crypto investor should appreciate that the market forces can result in no appreciable movement for months or years as has been the case for Bitcoin. See this post: Bitcoin: Is it a Ponzi Scheme? A Pyramid Scheme? Or a Bubble?

If you “must” put money in crypto , then my suggestion would be to trade.

As for me, I am happy to sit on the sidelines and enjoy the irony: a decentralized currency is not of use to the trader or investor unless it is valued against a centralized one.

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  1. I am no SME in crypto currency, but I do know Block chain will power the future of crypto currencies and the framework in which it would be operating – data standards, contract agreements, multi-party network arrangements etc.
    Seems RBI is keen in promoting its own crypto currency (Lakshmi). My belief is Big Boss won’t do it if it doesn’t believe in it! But whether trading will continue – I have no clue.

    1. Yes I agree. But the problem as of now is, cryto is too expensive for small transactions like one can do with say a Paytm. Currencies will always be traded.

  2. Very good article series.

    The “schematic” shows risk increasing with duration for equity and bonds which doesn’t seem to match the text:
    “Equity and bonds (capital markets) behave similarly. The risk over the long term is lower than the short term and it is range bound.”

    1. Yes you are right, the blue curve should not have sloped up so much! The problem with using schematics and not actual math.

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