One Chart You Must See Before Buying Bitcoin

Apurva Sheth

Bitcoin has been in the news the past few weeks. Japan announced it would be accepted as legal payment from 1 April 2017. The cryptocurrency has soared like a rocket after that. It's up 16% in the last two months and doesn't seem to be in the mood to stop.

Bitcoin is the world's first decentralised digital currency.

What does that mean?

Bitcoin is a digital payment method. You can use it to send payments directly over the internet without an intermediary like a bank.

With paper money, a government decides when to print and distribute it. But with bitcoin, it's different. Bitcoin uses a special software to verify transactions. After the transactions are verified, they are recorded in a transparent public ledger. The people who verify and process transactions - known as bitcoin miners - are rewarded with newly generated bitcoins. This acts as a control on the amount of bitcoin currency in circulation, which is more than we can say for central banks around the world.

Bitcoin has been around since July 2010 and have grown in popularity particularly over the last three to four years. There are many reasons bitcoin is gaining popularity.

First, bitcoin is an alternative financial system. People around the world are beginning to think the government and central bank-controlled financial system isn't helping us anymore. Every one of them is a potential bitcoin user.

Second, political and economic turmoil around the world is increasing. The central banks of developed nations like the US and the EU have been destroying the value of their currency with zero interest rates and quantitative easing. Countries like China have spiraling debt problems and strict capital controls. And here in India, 86% of bank notes went out of circulation after demonetisation in November 2016.

Bitcoin does well during times of financial crisis and uncertainty as it offers an alternative way to make transactions and store wealth. And that's exactly why bitcoin has run up in spectacular fashion. Here's the chart since the first bitcoin was mined in 2010.

Astronomical Rise in Bitcoin

Astronomical Rise since  Bitcoin

From US$0.08 in July 2010, bitcoin is worth US$2,876 as of yesterday. From an obscure start in 2010, one bitcoin is now worth more than two ounces of gold. But despite this run up, the total market capitalisation of all bitcoins ever mined is just US$36 billion. This is miniscule compared to the global currency market. This means there is lot of scope for further growth.

Now it's fun to read stories about bitcoin's explosive gains. But investing is not just about returns. It's about risk-adjusted returns. And as traders, we must maintain a balance between risk and reward.

You've probably seen that chart of bitcoin's meteoric rise before. But I doubt anybody has shown you the chart below before.

Drawdowns in Bitcoin since Inception

Drawdowns in Bitcoin since Inception

This is a chart of percentage drawdowns in bitcoin. A drawdown is a measure of the change in price from its highest high to current levels.

Bitcoin is clearly not for the faint of heart. The cryptocurrency has gone through regular bouts of extreme volatility since 2010. And the drawdowns are huge and very different from regular currencies or gold.

The biggest drawdown in bitcoin was of 93%. This happened in 2011. The second-biggest drawdown was in January 2015 when it crashed 85%. Many other bitcoin drawdowns have exceeded 60%. In fact, the average drawdown since inception is 51%. This means you can easily lose more than half of your investment in bitcoin.

How many investors would have the courage to hold an asset which is down 50%? Not many, I suppose.

It's hard to sit patiently on the road to recovery. To breakeven after a 50% loss, you need a gain of 100%. And the higher the crash, the higher the gain you will need to breakeven. Just have a look at this table.

Drawdown (%) Percent Rise to Breakeven
-10 11%
-20 25%
-30 43%
-40 67%
-50 100%
-60 150%
-70 233%
-80 400%
-90 900%
-95 1,900%
-100 Doomed
Source: dailyprofithunter.com

You'd need a gain of 900% to breakeven from a drawdown of 90%. Bitcoins have rallied smartly over the last few years despite major drawdowns. That's because the concept is still new and lot of people want to get in.

But once the idea becomes mainstream, the gains can take a long time. And until then, there is competition from other cryptocurrencies. As of now, there are more than 800 crypto currencies in circulation. Early investors in bitcoins are booking profits and investing in these relatively new currencies.

Any investment is a balance between risk and rewards. You can't focus on one and ignore the other. With bitcoins, the rewards are high, but they come with substantial risk. If you're considering buying bitcoin at these levels, give a thought to the risks as well.

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Market Notes

What Will Take Gold to 40,000?

Indians can't hide their love for physical assets. We panic when stock markets crash. But a fall in gold prices brings cheer, as many rightly see it as an opportunity to buy more of the yellow metal.

Stock markets in India are now at lifetime highs while gold is 16% off its high (and has been down as much as 30% in July 2015 from its all-time high). The yellow metal has been out of favour with Indians going on four years. So what will it take to bring gold back?

In the chart below, we see that gold has been consolidating between two horizontal lines. Whenever gold goes up, it finds resistance at the upper line. And when it goes down, it finds support at the lower line. A breakout on either side would lead to a big trend in gold prices.

The best way to take advantage of big trends in gold prices is through derivative market. If you are new to derivatives, we have created a special guide that can help. This guide will help you to capture big upcoming trends in commodities market with small investment.

All you have to do to get your copy of the guide, is reconfirm your subscription to the Daily Profit Hunter newsletter.

Gold Consolidating

Gold Consolidating

What are the chances gold will break on the upside?

We We all know gold is a 'safe haven' asset, a 'risk-off' asset. During times of uncertainty, people swap 'risky' assets like stocks for 'safe haven' assets like gold.

With stock indexes around the globe at or near all-time highs, the stock markets are definitely vulnerable to a significant downside correction. Whenever the stock market declines significantly, one of the first alternative assets investors look at is gold.

A correction in stocks could be the catalyst that breaks gold's horizontal resistance line.

Now, for Indian investors buying gold in the local currency, the value of the Indian rupee vis-a-vis the US dollar is crucial. For example, if the gold price in the international market is stable but the rupee falls 10% against the dollar, the price of gold in rupee terms will appreciate.

So apart from the price of gold in the international market, the value of the rupee plays a major role in driving your gold returns.

Recently, the rupee appreciated more than 7% from its November 2016 high of 68.88. This makes the currency more vulnerable to downside correction. Any significant correction to the rupee could fuel gold investment in India.

A risk to gold prices are rising interest rates. Higher rates would decrease investor demand for non-interest-bearing gold. That's because high interest rates make bonds and other fixed income investments more attractive than gold, which offers no yield at all.

The US Federal Reserve said it wants to raise interest rates three time this year (it already did so once in March). This would not likely bode well for gold prices in international markets. But some recent soft US economic data has raised questions as to whether the Fed will be able to stay the course.

Even if Fed is able to raise rates again this year, it would mean a strengthening US dollar, which would lead to a depreciation of the rupee and thus a rise in gold prices in the local currency.

However, the last two times the Fed raised rates, gold in dollar terms bottomed the following day, indicating the rate hikes were already priced in. If that pattern continues, the gold price in rupee terms might receive a dual kicker. First from absolute gold prices and second from rupee depreciation.

Considering the above, if we see stocks cool off and the rupee depreciate, gold might well go up and break the resistance line and move toward a new life high.

Does that mean you should start speculating on gold?

No.

Gold is not an investment to make quick gains. It's role in ones portfolio is diversification and insurance against global uncertainty. We believe a 10-15% weightage in gold is an excellent way to de-risk one's portfolio.

From The Market Wizards...

"If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in." - Paul Tudor Jones

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