One way to trade a Bitcoin halving
If you were wondering what disruption looks like – actual disruption – well, what happened in March 2020, will give you a very good idea.
Markets crumbled. Bitcoin and the entire crypto space got creamed. The speed of these declines is breathtaking and arguably, unprecedented.
These are extraordinary circumstances, but they also provide traders with unique opportunities. One of those opportunities is to use the recent repricing of Bitcoin.
What follows is a big picture trading perspective that will explain the current context and combine it with the thought process around a catalyst type trade. The catalyst or event is the halving.
For crypto traders that have been at it for a while, the extreme volatility is a bit more familiar. In equity markets, a decade of relatively calm seas for current participants have been interrupted by moves that eclipse even those of the volatile crazy era from 1998 to 2010.
The reason for the commentary on other markets is that these have and will impact crypto markets. Therefore the movements and the events surrounding them become part of the context of current events and any trading decision.
This is disruption
How to develop a trade around the upcoming Bitcoin halving
First, we will look at the context of the environment we will be trading in, including world events affecting other markets. All of these can impact trading decisions in BTC.
We will also explore what’s going on in the market and compare it to other times. Plus, we will see how past events have shaped today’s market structure and expectations around future events when the market is in flux.
Next, we will take a look at the various narratives that surround an asset like Bitcoin. We’ll take a look at whether it’s a safe haven or a hedge. And we will look at why the pricing in of the halving is now irrelevant.
After that, we will take a look at some things we already know about how different players in a crypto market operate. Here we will explore the influence of automated trading and how the market structure is influenced by various market participants.
Using this backdrop, we will look at one way to develop a swing type trade in Bitcoin based on the halving catalyst.
But first, a disclaimer.
What this is and what it isn’t
I want to make it clear what this is and what it isn’t. This is a commentary on the thought process of developing a trade. It is purely informational.
The legal team would like to make you aware that, just like all of the content on our website, the commentary that follows and any related content are provided for general information purposes only. This information is NOT INTENDED TO AMOUNT TO ADVICE OF ANY KIND UPON WHICH YOU SHOULD RELY.
Translation: This is NOT trading advice. It is also NOT investment advice.
And to add to that, I want to make it clear that there are many ways to trade a market. There are many different opinions and approaches on how to trade an asset and a situation.
So whether you agree or disagree isn’t the point of this. This is designed to help traders who may be less experienced or shellshocked by recent events. The mission is to help them think about the market more broadly and develop their own approach and skillset.
Before we shape the trading idea, we have to first set the stage and add some context.
Crisis 2020 vs. 1998
Now, quite a few of you weren’t doing any trading back in ‘98, but that period seems relevant to now. There was a financial crisis brewing in Asia through 1997 into 1998 that we all heard about. However, North American markets were mostly oblivious to it. Nobody appeared to be concerned about what was happening in Asia at all.
Then one day in the summer, things started getting real.
A default on Russian debt set in motion a series of events. Markets across the globe went from calm seas to Cat 5 hurricane. Long Term Capital Management blew up as spreads in their vast portfolio of leveraged, illiquid positions all went in the wrong direction at once.
As the whale in these illiquid markets with lots of leverage, LTCM had nowhere to go when things went sideways. Add to that, their previous success attracted numerous hedge funds who piggybacked those same trades exacerbating the problem.
So we have leverage, illiquid assets, and a strategy designed to profit from calm seas, a brewing financial crisis in Asia and a catalyst, the Russian default.
In 1998 the Fed was forced to step in and gathered the banks to put their balance sheets to work by investing in LTCM. They also lowered interest rates 25 bp in September, then again in October and November.
Coming into 2020, we had calm financial seas, extreme leverage worldwide, but this time, a biological crisis brewing in China that nobody seemed to care much about initially. Then came the catalyst when it spread rapidly and hit other nations, effectively shutting them down. Whole cities in quarantine became entire countries, and economic activity started grinding to a halt.
The Fed has responded with extraordinary monetary measures. These include an emergency 50 bp rate cut and an injection of hundreds of billions in repo market liquidity. Rates were subsequently slashed to 0% on March 15, and a massive QE program was announced. And several other central banks, along with their nations, are also taking extraordinary measures.
But the big banks aren’t part of the solution this time because they’ve been neutered by the Volcker rule. That rule, prohibiting many forms of trading at banks, was instituted after the Great Financial Crisis in 2008.
It seems like 1998 in terms of the story, but the results have a very 2008 look to them.
Today, the only buyers of last resort are the Federal Reserve and other central banks.
And it was the events of 2008, 2001, 2000, 1998 and probably others, that precipitated other outcomes including development and release of Bitcoin.
Untested financial products and services will fail
When a catastrophic situation becomes recognized by a market, things get real in a hurry, then reality settles in.
And when markets meet extreme stress, all the products, services, personal, rules and systems created since the last crisis, get tested.
One prominent fintech couldn’t keep their platform up on a couple of days during the market rout. A couple of giant financial institutions had temporary problems with their systems as well. A well known crypto offering got shanked. And rumours are swirling that some global hedge funds had their heads handed to them over the last couple of weeks.
We will be hearing more stories of financial products, fintechs and fund managers that have failed the market’s stress test. These failures alter people’s confidence in various narratives and market perception in the short and long term, including crypto.
The swiftness of market moves across assets in the modern markets is a byproduct of changes in networking, market structure and trading behaviour.
And one of those is the dominance of algorithmic trading.
How algorithms impact trading
Most orders in a modern market bid-ask spread are placeholders. That means computer-generated orders designed to work the spread. They don’t care about earnings, interest rates, or anything else. Their focus is 100% on price, flows, maker fees and risk management.
These algos are the modern version of the terminator as a trader.
For example, in the past, a 1000 share order in the traditional market was one order of 1000 shares. Today 1000 share order is ten orders of 100 shares.
So when a sell order comes in and fills the first couple of 100 share orders, the balance of 100 share orders are quickly pulled or cancelled. Then the algorithm races up the “pipe” to other liquidity pools to sell ahead of that sell order. The algos then get in front of the order and lower the bid.
Now imagine hundreds of algorithms doing the same thing across the spread and throughout the order book.
Other than racing up the pipe to get ahead of the existing order, the rest is all normal stuff. It’s the way old market makers and grinders made their living.
One difference is speed. The other difference is the proliferation of placeholders throughout the order book as algos compete for flow. This development obscures the real spread, which becomes suddenly much wider when the market starts to exhibit some flow imbalances.
Even crypto trading in the most liquid assets also includes algorithmic strategies. Crypto has “bots” where regular markets call it program and HFT trading. These strategies shape market movement and drive some of the violent moves we see.
Let me explain.
All markets have a fractional reserve like system
Watching the market dropping several percent in record time recently, you can see this process in action.
The market is a bit like banking, in that it’s like a “fractional reserve model.”
Banks hold a small amount of reserves relative to the credit extended. As long as all their clients don’t come in at once to demand deposits, everything runs smoothly.
In the market, if a relatively balanced number of the total pool of buyers and sellers participate in an orderly way, everything is good. There are adequate bids and offers to absorb the activity. But when several large sellers (or buyers on a short squeeze) roll in, things start to come apart.
Add in margin trading and leverage, and it looks like a bank run when a flood of people come in to pull their funds.
So a large seller starts hitting bids in the market and the placeholders reduce bids, run up the pipe and sell ahead of the order in other liquidity pools. Then they offer in front of the order.
When the algos soak up to much inventory and more selling rolls in, they go into risk management mode. They will blast out their holdings indiscriminately and reset their placeholders as a spread at lower levels. The algos then walk down the order to the uncle point, clean it up and typically reset the price higher.
But in the meantime, their indiscriminate selling triggers all kinds of stops, and margin calls on levered participants while they drive down the price to the clearing level. And if things get crazy enough, they pull all their placeholders and simply stop trading altogether.
Corona Ruh Roh!
When the market suddenly goes from “Whatever bro” to “Ruh Roh!” like they did in March 2020, lots of sellers come in as portfolio rebalancing takes place. Algos get blown out, stops get triggered, and the sellers overwhelm the weak market structure.
So when you are trading Bitcoin, for example, gaps and violent moves reflect market structure and the influence of orders outside the market’s “fractional reserve” norm.
A few good-sized orders tap bots, the bots go into risk management mode and react, setting in motion a temporary domino effect lower. Although Bitcoin doesn’t have the pipe that attaches all the various liquidity pools together, it now has margin trading that will exacerbate these moves lower.
Why is this important?
If you are building a position in Bitcoin, you need to keep this in mind to plot out your trading strategy. The moves precipitated by these activities will help a trader build a position and trade it around.
Because as we have seen quite vividly, there’s going to be some…surprises.
Trading Bitcoin with leverage has consequences
During a decline, a lot of things are set in motion.
Margin call liquidations start coming in, and these are executed without mercy at the beginning and end of the day. Margin liquidations precipitate more dislocations in a leveraged market.
Crypto is just getting a taste of margin trading, and some people are using 100x margin to trade various BTC products. Now combine these sellouts with algo market structure, and you can see where some of the violent moves come from.
There are also problems that emanate from other parts of a market, like asset managers and hedge funds. Some of these use leverage extensively to juice returns, and when a storm comes, this exacerbates the problem.
Then there are the fund redemptions that act like slow motion margin sales. These are usually orderly affairs unless demand for redemptions and market conditions worsen materially. In 2008 a perfect storm of events sent investors hunting for cash anywhere they could access it.
A bunch of capital was stuck in a failed Lehman, and several funds suspended redemptions to keep from further damaging investor capital. This sent investors to the funds that weren’t locked up.
Any fund that wasn’t locked down had to sell to meet the flood of redemptions that the other funds wouldn’t give. That precipitated more selling, putting more pressure on levered positions.
So it’s possible that due to the swiftness of the decline in the regular markets, Bitcoin positions are being liquidated to raise cash. And it’s highly likely that margin trading in Bitcoin across futures and regular markets is leading to numerous forced liquidations.
Changing perception of the Bitcoin hedge
One of the underlying narratives about Bitcoin is that it is a hedge or digital gold. What it’s a hedge against isn’t always clear. The clearing structure of the asset itself could be considered a hedge, but owning it priced relative to other assets it may not be.
This somewhat vague, unclear definition of Bitcoin as a hedge, has implications when things get real.
As events unfolded, Bitcoin did not take off. Initially, it was not sold hard, but it did fade a bit. Then it got clubbed on March 12. So when Bitcoin gets creamed when the market declines, it challenges the weaker narratives associated with it.
Bitcoin vs S&P performance March 2020
Those that perceive the word hedge as being like a portfolio hedge may have a significant shift in perception as a result.
But if you are developing a catalyst trade with several weeks to build a position, having all this risk suddenly removed from the trade creates a unique opportunity.
Is Bitcoin a hedge? I don’t know. Is it money? It doesn’t actually matter. For the purpose of this catalyst trade, it will be treated as an asset more like a volatile stock than a currency or a hedge.
A trader should be aware that people consider it a hedge, or money or a currency, but this isn’t entirely relevant to the mechanics of the trade itself. In fact, you should be aware of these arguments, but generally, ignore them and focus on your own thinking, trading rules and execution.
It might be more accurate to look at Bitcoin as a part of a broader asset ecosystem instead of a hedge. When you see it this way, you can see it’s behaviour during this period in light of what happened in 2008.
Price chasers and whales
Now the next element we should consider is the way market participants operate in the market.
We know that Bitcoin is 24/7 and international, so no gap opens and closes like in the legacy markets…
We know that retail traders are mostly price chasers, meaning they buy aggressively as prices rise and disappear as prices fall.
We also know that large orders from “whales” can have a disproportionate impact up and down on prices due to market structure and algorithmic or bot trading.
We know that there is now leverage inside the crypto ecosystem and that liquidations are highly likely given crypto’s inherent volatility.
And we also know that the Bitcoin network has not gone down regardless of market stress.
Robinhood was down at one point, so was J.P Morgan, but Bitcoin was not.
It may even be easier to buy Bitcoin right now than toilet paper in some places.
Bitcoin halving assumptions
The Bitcoin halving is a seminal event. It will signal that Bitcoin is one step closer to its fixed coin target resulting in fewer rewards for securing the network. Miners will require rewards to exceed mining costs, but they will also have fewer Bitcoins to sell, so perhaps less selling pressure from that source.
And of course, around the last halving, July 9, 2016, Bitcoin rallied, so everybody is expecting that to happen again because, well, it’s a “pattern”…of one.
The talk about the halving has been going on for some time. Some say it’s priced in. Others say not. In light of recent declines, likely, it is no longer priced in even if it was.
It doesn’t matter what the actual answer is. The question is, how can one explore the current sentiment and develop a short term trade to take advantage of any upside?
Setting up the catalyst trade
The decline during this event is actually a good thing. It reduces some of the froth in the asset leading up into the halving, making it easier to build a good position.
A key point is that any trade is simply a hypothesis that requires testing, execution and risk management. So when you set up a trade, be clear on the reason and time frame. The reason is to develop a trade based around a catalyst, the halving, which will occur in early May.
The idea is to exploit downdrafts to build a position in Bitcoin in advance of the catalyst. There can be a core position that can be held while the balance is traded around to take advantage of volatility.
As the catalyst approaches, the trading part of the position can be scaled out and the rest can be held into the event with tighter stops as long as the market warrants.
Trading with tranches
So let’s say we have 5000 bucks to play with. Divide the stake into tranches for deployment.
This could be ten lots of $500. One can build a position as Bitcoin ebbs and flows, and sell some back on quick rips higher to build a cushion.
To reduce time moving in and out of the market, a trader can convert the funds to a stablecoin like QCAD first, and deploy them as opportunities present.
Each lot should be entered as a limit order to avoid getting hosed by the crypto market makers. If you don’t know what a limit order is, it’s an order with a specified price rather than buying (or selling) at whatever price you can get.
Given the inherent volatility and price discrepancies across crypto markets around the world, you should never use market orders.
Buy some for a taste
The first $500 might go out wherever the BTC market is at the time, to get a taste. Without some money on the line, one won’t think as clearly about the trade. Even having a small position on changes one’s attention and thinking.
This first allocation should not have any hard stops. Let the market move around while looking for strategic places to add more tranches.
With the first buy done, the next step is to decide how many days or weeks you will use to deploy the balance of the money and where. Part of this means shaping expectations of what might happen as the trader builds the position.
Shaping these expectations leading up to the catalyst is psychologically important.
Then prepare for the unexpected
Anticipate that two things are likely to happen in advance of Bitcoin’s halving.
The first is an “unexpected selloff” or series of selloffs and bounces. With the virus moving around the world, the markets getting tagged and with people stuck at home glued to Corona news, irrational behaviour is likely.
We’ve already seen some ugly selling, and there may be more temporary pressure as margin positions are reestablished and blown out into weakness or stop hunting.
Several ugly selloffs
A trader can use these sell-offs to reduce overall position price by “averaging in” and using sales on rips higher.
So when Bitcoin comes in, the trader can buy 500 QCAD worth of Bitcoin. One doesn’t have to be in a rush. It doesn’t matter if the trader doesn’t put it all on during a big drop, they can always add later. The idea is to use weakness to add where it’s advantageous.
Watch for stop hunters
A trader should also look for logical places for stops to be triggered. Sometimes that’s round numbers or “support” on a chart. It might be a price that everyone is jawboning about on social media. Whatever it is, if enough positions are vulnerable, stops will be triggered.
When it happens, in addition to building your position, take note of what the lowest price is where the selling occured. This price will a better indication of existing market support.
One can also anticipate sharp lifts from time to time, which will show where the selling is. This range will provide places to sell a tranche of BTC and move back to QCAD while waiting for another decline to add that piece back.
Why expect these things?
Because when they are a surprise, they cause fear and doubt. If these moves are not expected, they can be unsettling and interfere with a trading plan.
But if you expect them as a possibility and plan for their eventuality, whether they happen or not, one will know exactly what to do and how to handle them. These moves go from surprises to possibilities. They move from threat status to opportunity status.
Build the catalyst position
As the catalyst event approaches, the trader will likely have most or all of the position on. Now it’s time to decide what the core position will be and how much will be sold. For example, the trader may decide to lock in gains on 50% of the position while holding the balance for a run.
Catalyst trades aren’t like options, but they have a sort of time value to them. The time value is because of the fact that a market is a discounting mechanism. So the closer you get to the anticipated event, the more likely it is that the event can be priced in.
The closer it gets to May, and the closer Bitcoin gets to the price before it was recently clubbed, the more risk the position will carry.
So one should be looking at this decision a couple weeks ahead of the event. And part of that decision will be tightening up the stops on the balance of the position while exploring where to sell and or scale out the held position on a lift.
Protect yourself with house money
If BTC offers enough volatility and recovers into the end of April, the trader will have “house money” to play with. House money is a psychological term for profits that allow a trader more risk tolerance and more flexibility to maintain a position through a big move.
The idea being that the trader separates the principal, which is his or her money, from the profit, which is the house’s money. When the principal or your money isn’t at stake, you have more psychological flexibility in turbulent conditions.
As we can see, asset markets, regardless of clearing or network, are interconnected by their users. Bitcoin is no longer a backwater niche market, but rather a part of a larger matrix of assets. Therefore the whole picture should be considered if trades are developed with longer than day trading timeframes.
Turbulent markets are the playground for traders, and markets in flux provide the kind of experience that is worth more than years of calm market seas. Lots of traders get only a year’s worth of experience in a decade. Players in this environment will get years of experience in a few months.
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