Mimesis Capital: Inside the Event Horizon, Report # 15
Why is Bitcoin’s price making random, sudden downward movements?
A common disadvantage of Bitcoin is that it is “too volatile”.
There is no denying that Bitcoin is a volatile asset. Price action supports this conclusion in almost all time frames (including minute, hour, daily, and yearly).
However, volatility isn’t necessarily a bad thing. Indeed, volatility creates opportunities.
Over a long time horizon (4+ years), Bitcoin’s volatility was mainly upward. Using this longer time horizon helps eliminate the noise and focus on the signal.
Volatility and return can be assessed using the so-called Sharpe ratio, which measures the risk-adjusted return. The Sharpe ratio is the result of dividing the return on the asset by its risk / volatility over a 4 year HODL period.
Data on Woobull
Bitcoin’s Sharpe ratio has been higher than any other asset class throughout its existence. This is one of Wall Street’s most popular financial metrics, and it screams “buy bitcoin” as it shows that the return on holding bitcoin more than made up for holders for their historical downward volatility.
Big, quick downward movements
Why does Bitcoin have such large, sudden downward price movements? What is causing these massive corrections in such a short time?
April 18, 2021
February 22, 2021
March 12, 2020
Unlike stocks (stocks), which tend to trade aggressively on profit days (days when company performance and future forecasts change fundamentally), Bitcoin trades aggressively on seemingly random days.
This strange phenomenon tends to confuse traditional commentators and journalists as they struggle to find news that could have affected the price so drastically.
At some point someone comes up with a possible explanation that is immediately circulated due to confirmation errors.
Examples:
- “Bitcoin has fallen 10% because of Biden’s tax hikes”
- “Bitcoin has fallen by 10% due to a (false) foreign exchange inflow of 10,000 BTC”
- “Bitcoin has fallen by 10% because Yellen pushes for a capital gains tax of 80% on crypto” (Fake News)
Although a small number of individuals can place buy or sell orders based on one-time messages, they are likely not the only drivers behind the sudden bitcoin price drops that we see on a regular basis.
In reality, many people who retweet and spread the news that the price of Bitcoin has crashed because of X are simply “being fooled by chance”.
Use liquidations
Although X can be one of many catalysts, the large downward movements are often driven by excessive leverage in the system.
This can confuse some people because, by definition, there must be a seller for every buyer of a futures or perpetual swap contract. However, the prices of these contracts will change depending on the market balance between long and short positions.
For example, a funding rate is charged that helps the exchanges match the perpetual swap price with the spot price. If general market sentiment is long, the funding rate likely causes longs to pay shorts every 8 hours. For this reason, Bitcoin futures contracts are traded in contango during a bull market.
Unchained Capital’s Parker Lews explains leverage liquidations well by stating that “Bitcoin eliminates imbalances.”
If there are too many leveraged long positions on Bitcoin without simultaneous buying pressure on the spot market, the current price may temporarily not be sustainable.
As @WClementeIII explained, an over-indebted market resembles a Jenga tower built on a fragile base. If the funding rates and the futures contango are extremely high on the spot market without significant buying pressure, the Jenga tower only needs a slight boost before it collapses.
These leverage liquidations create an ugly negative feedback loop:
- Price falls.
- Long positions with high leverage are liquidated (force seller).
- Price keeps falling.
- Long positions with low leverage are liquidated (more forced sellers).
- Traders see falling prices and jump on the trend.
- Price falls.
- Repeat until the fragility of systemic leverage is eliminated.
This imbalance, driven by excessive leverage, creates volatility. This volatility causes coins to be transferred from weak hands to strong hands that understand Bitcoin. After weak hands sell, the price has to adjust to the new equilibrium.
Then a new base of strong holders is built at a more sustainable price level, and then Bitcoin’s parabolic bull run continues as it has for more than a decade. This is all due to the fact that because of its superior monetary characteristics, individuals theoretically converge on Bitcoin as the Schelling point.
Contangos? Hyperbitcoinization?
Some may ask, if excessive leverage is a major cause of these sudden price movements, how can the contango of the futures curve for Bitcoin be good, especially when the curve is driven by demand for leveraged long Bitcoin purchases?
First, contango base trading still exists, and it is profitable for a low risk USD trader to buy spot, sell futures, and capture the spread. However, if the curve gets too high without enough capital coming in to execute the base trade or buy the spot, the contango / funding rate could become unsustainably high.
If the funding rate or contango curve gets too high without significant buying pressure in the spot market driving the price up, the price could be driven up on a fragile basis by leveraged longs with high funding rates. If so, it could potentially crash violently.
This is a guest post from Mimesis Capital. The opinions expressed are solely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
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