Bitcoins: Too Hot To Handle

Bitcoins have captured the imagination of everyone. Even people who have never invested in stock markets have started talking about the crypto currency. Bitcoins are the talk of the town right from college students to diamond brokers to housewives.

If the whole world is talking about Bitcoins then how can CEO of a top notch investment bank miss it? Bitcoins crashed recently after JP Morgan Chase CEO Jamie Dimon called it a fraud.

"It's worse than tulip bulbs. It won't end well. Someone is going to get killed," Dimon warned. Apart from this China also announced that it will shut down all the Bitcoin exchanges in the country.

This double whammy pushed Bitcoins from a high of 4,950$ on 2 September to a low of 2,950$ on 15 September. That's a drop of 40% in a fortnight. Bitcoin has bounced back smartly from the lows but it's nowhere close to the prior highs.

The price action for the last month or so has been too hot to handle for many. It's exciting to see the price double or triple quickly. But it's worse when it falls forty percent in a fortnight.

If you are planning to invest in Bitcoins then here is a chart you shouldn't miss at all.

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

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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2 Responses to "Bitcoins: Too Hot To Handle"
soman chellappan rakku
02 Oct, 2017
to buy one bitcoin how much indian rupees to pay ?Like 
ashok panchal
21 Sep, 2017
article is very much useful and in simple manner so any one can understand. thanks Like (2)
We request your view! Post a comment on "Bitcoins: Too Hot To Handle". Click here!