How to Harness Volatility with Digital Assets

The rise of cryptocurrencies has given birth to an entirely new digital asset class. In just over a decade, blockchain technology has created more than a trillion dollars in market value.

More than 40 individual coins have surpassed the “unicorn” designation of $1 billion in value, and the question many investors are asking themselves is “how to enter this white-hot investment landscape without getting burned.” 

While the number of tokens and digital currencies can be dizzying to uninitiated, FOMO feelings from those sitting on the sidelines, have become palpable. Bitcoin rose over 300% in 2020 alone, and Ethereum logged a cool 588% return for the same time period.

But for every year, these crypto darlings outpace traditional assets; naysayers are quick to pour water on the investment thesis. “The space is too young! Unproven! Too Volatile!” they say. 

And so, cryptocurrencies have predominantly existed in the retail investment space, overlooked by mainstream financial institutions – that is… until now. 

Besides being forever remembered in history as the year of COVID, 2020 also marked a watershed moment in cryptocurrency history, mainly: an onslaught of institutional investors pouring capital into digital assets like Bitcoin and Ethereum.

And while it might be fun to carry on the Twitter debate about the value and longevity of this burgeoning digital economy, when Goldman Sachs, J.P. Morgan, Blackrock, Mass Mutual, Paul Tudor Jones, and Ray Dalio make an about-face on a previously unloved investment idea, it’s probably worth taking a closer look. 

This article will examine the real risks of owning cryptocurrency assets and uncover why volatility, as it pertains to any investment, is not something to avoid wholeheartedly when building a well-rounded investment portfolio. 

 

Key Takeaways

 

  • All assets have a non-zero chance of becoming worthless.
  • Even the S&P 500 has spent most of its time (66%) declining from 2000 – 2020 but is still thought of as a great investment.
  • Bitcoin has all the properties of sound money, including portability, scarcity, durability, divisibility, acceptability, uniformity, and fungibility.
  • Ethereum has slowly matured into sound money and is considered digital oil to Bitcoins digital gold.

 

What’s the actual Risk of Digital Assets?

 

The risk to any investor is simple. It refers to irrevocable loss. Not just a drawdown or temporary pullback, but true loss. A loss that can’t be easily or quickly recovered. Sometimes it happens as a result of volatility – think 2008 financial crisis or the 2001 tech bubble.

Sometimes steep drawdowns cause us to give up a position or “realize a loss” because we genuinely think that “this time it won’t recover” or “I’ll repurchase it cheaper.” 

Occasionally, our stubbornness gets the best of us, and we ride an Enron or WorldCom to the bitter bottom. Still, more often than not, pullbacks represent a visceral gut check that causes us to question our resolve. Take tech titan Apple as an example.

Even the biggest company in the world isn’t immune to the occasional sucker punch. The chart below shows that from 2000 to 2020, Apple suffered from nine severe pullbacks, greater than 20% from peak to trough, with 7 out of 9 eclipsing a 30% pullback, and one of which surpassed a soul-crushing 80% pullback. 

Despite this volatility, we all agree that Apple has been one of the best performings and most widely held investments of the last 50 years. What might be of greater interest and hold more statistical significance is the total recovery time from peak to the trough when we witness these periodic downturns. 

On average, the time it takes from the dead lows to reclaim the previous high was 355 days. If we remove the outlier – the -80% drawdown event from 2000, which took just over 4 years to recover – the average was 213 days or just over 7 months from trough to peak.

The total time spent in drawdown, peak to trough to peak, is 4413 days or just over 12 years! (2649 days or 7.2 years without the 2000 bloodbath).

So if you held Apple as a core investment over the last 20 years, chances are you felt some pain for 40%-60% of the time you held. That’s astonishing when you think about what we consider sound investments, and while this is only one example, major indices and ETFs aren’t far off from these metrics. 

Let’s examine the S&P as a more broad-based and diversified example. 

If we review the same time period, we find that the S&P has suffered 4 major pullbacks from 2000-2020, declining more than than 20% from peak to trough, and spending more than 13.3 years (66% of the time measured) declining, or attempting to recover its previous high. 

So the real risk in this example isn’t so much the risk of permanent, irrevocable loss, but the risk of drawdown, which is transmuted into loss because we submit to pain and fear. Humans (and investors) are programmed to survive, and when we see losses start to accumulate, our survival response kicks in as we attempt to remove the things that threaten our survival.

In the investment world, that means drawdowns. But the question we have to ask ourselves is this: “will this company or currency or economy become worthless, or will it recover?”  Perhaps more relevant to this example, “will I ever stop buying these iPhones?” 

 

So what’s any of this got to do with Bitcoin and Ethereum? 

 

The majority of sound investable assets do not lose all of their value, and as is the case with US/Global Stock Indices, generally trends upwards over time. 

So now we turn to the new kids on the block: 

Are cryptocurrencies here to stay? Or are they just the latest finance fad? 

 

All Assets Have a Non-Zero Chance of Becoming Worthless

 

Yes, it’s true.

Everything can become defunct, bankrupt, dethroned, replaced, nullified, or just plain useless. In its rise to the top, how many industries did Apple supplant to become a $1 trillion company? Camera film, DVDs, Blackberrys, maps, yellow pages, the list goes on… all of them suffered massive losses or became virtually non-existent after Apple released a phone that didn’t have buttons, a camera that took unlimited pictures, and the internet became something we carried with us everywhere.  

And yet, there is currently a non-zero chance that Apple will become worthless at some point in the future, as unlikely as it may seem. Given that truth, we must then accept that all assets have the inherent risk of becoming worthless and set out to analyze the probability of that occurs within a time horizon that is meaningful to our investment duration. 

Enter digital assets. 

If we accept that all assets share the common risk of going to zero but are willing to handicap that risk in terms of probability, we can set out to analyze the real risk of owning digital assets like Bitcoin and Ethereum in an investment portfolio. 

 

Do Bitcoin and Ethereum Have Staying Power?

 

Short answer, yes. 

In one of the easiest to understand analogies to date, the two top cryptocurrencies were described thusly: Bitcoin is digital gold, and Ethereum is digital oil. 

We needn’t spend an exorbitant amount of time rehashing this explanation, but suffice to say, Bitcoin demonstrates (very well) the properties of sound money, which are as follows: 

For money to be an adopted form of currency, it must be: 

  • Durable – stored on a decentralized network = can’t be easily destroyed. 
  • Portable – very easy to carry and transport 
  • Scarce – digital scarcity – 21 million coins total, ever. 
  • Acceptable – accepted as a transfer of value between parties.
  • Uniform – Bitcoin is the same everywhere in the world
  • Divisible – easily divisible
  • Fungible – one bitcoin can replace another and can be used for any purpose

While all of these qualities are essential in creating a monetary system, perhaps the most desirable Bitcoin characteristic is its inability to be duplicated. Unlike every other fiat currency, Bitcoin is technologically limited to a finite supply that cannot be breached. 

This is one of the strongest arguments for its utility as a store of value and a tool to hedge against inflation. It is undoubtedly a key factor in the widespread accumulation of Bitcoin by institutional and retail investors alike. In a world where owners of money have zero control over the rate at which it gets printed (and devalued), digital currencies introduced a new layer of control to their owners. 

Digital oil, as it were, might be a more difficult concept to grasp, but suffice to say that Ethereum, like oil, has wide-ranging use cases and applications. Like oil can be turned into fuel, plastic, and lubricants. Ethereum is the base (digital) element used to create digital applications, new cryptocurrencies, and entire systems of decentralized finance; from there can be used in an endless list of applications. 

Both of these assets have large first-mover advantages, and because of that, enjoy a substantial defensive moat in the way of market capitalization. As each of these assets becomes more mainstream, they create their own self-fulfilling confidence loop. A larger overall market cap generates greater acceptance from the investment community, increases buy-in, increases market capitalization, and around and around we go. 

As mentioned previously, 2020 marked wide-scale adoption from global financial institutions, and the momentum continues to build. One expectation as these firms gobble up the supply of digital assets is that these investments’ overall volatility will begin to subside.

As retail speculators with short time horizons represent a smaller share of the digital pie, too will speculative positions and overleveraged margin accounts become less common, giving way to large corporate holdings that are stored offline and reduced the traded supply. 

Already we’ve seen demand from companies like Paypal, Square and Grayscale far outpace the daily mined supply of Bitcoin, which has created a price floor that continues to move higher as these institutions take supply into their digital vaults. 

 

Enter Options

 

The best way to benefit from volatility and protect oneself from downward moves is by participating in the options market. With an intelligent options strategy, even the most volatility of assets can be managed. 

Bitcoin and Ethereum options markets have grown exponentially in the past few years, with +1800% growth in options volume in 2020. This both signals a maturation of the digital assets market and institutional investors’ entrance that can use options strategies for their benefit. 

Though the array of strategies for risk-managed and defined-risk trading with options can be enumerated ad infinitum, simple strategies include purchasing put protection and financing it without the money call-selling and mining “Vega” (volatility premium) to finance puts. 

An array of metrics can determine how hedged one wants to be during certain market cycles that vary depending on the asset. 

 

Volatility is an Opportunity

 

The incredible amount of volatility in the digital assets markets makes options trading a great benefit for those with experience. As a means for protecting a portfolio, added volatility functions as a benefit, and options trading can put known parameters on the risk being undertaken.

For assets with cyclical, exponential growth like Bitcoin and Ethereum, riding these highs while maintaining some protection makes a lot of sense, turning volatility from foe to friend.