After getting lost in the desert your eyes can start playing tricks on you. You start seeing water, palm trees, civilization, or maybe an endless cryptocurrency rally. Crypto winter was not the desert but it certainly created a lot of pain in the crypto world. Folks who leveraged all of their wealth in attempts to become mega rich got wiped out. Now there may be a Bitcoin-related mirage. Bitcoin is back to nearly its all time high and so is the use of crypto leverage. The moral of this story comes first. You should not be using leverage on your crypto investments with money that you cannot afford to lose.
What Is Going On With Bitcoin?
The latest Bitcoin surge has taken it close to its all-time high. What is driving this resurgence? The quick answer is that spot Bitcoin ETFs have delivered on their promise to bring tons of new investors into the Bitcoin world. The stated rationale for spot Bitcoin ETFs has been this. Folks think they can make money with Bitcoin but are afraid of crypto hacking, uncertain about using the blockchain and a crypto wallet, or simply not interested in all the work involved in a Bitcoin investment. Contrary to buying and selling Bitcoin directly, a spot Bitcoin ETF works like a stock. One buys and sells in dollars and does not worry about hackers stealing everything they have invested. However, there appears to be more to the current Bitcoin surge than just interest in spot ETFs. Leverage in the Bitcoin world has come storming back.
What Is Bitcoin Leverage?
Bitcoin leverage is the ability of an investor or trader to increase the size of their Bitcoin position by borrowing funds (dollars). With a ten-fold leverage one controls ten times the amount of Bitcoin that one would have without borrowing money to create leverage. The upside to leverage the investor is that it creates a much greater profit potential. The downside of Bitcoin leverage is that it greatly increases how much one loses when the market moves contrary to expectations. For the Bitcoin market, excessive use of leverage greatly increases the likelihood of a short squeeze.
What Is a Bitcoin Short Squeeze?
A short squeeze is not limited to crypto markets but is common in any market where options trading and short selling are allowed. An asset is in a rally. Some traders expect excessive enthusiasm to drive prices beyond what the market will eventually support. Thus they “sell short” or purchase put options allowing them to sell at a set price no matter how far the market might fall. The problem for the contrarian is that when the market keeps going up they eventually need to step in and buy to keep from losing all of their money. This buying pressure drives the market even higher. These short sellers or put buyers are “squeezed” which gives this upward market movement its name. The problem for the average Bitcoin investor is that they see the market go up and decide to buy into what they see as a continuing rally. Unfortunately, short squeezes last a few day and the market retreats. Naïve investors who thought this was more of a rally lose money virtually as soon as they get into the market.
Is the Bitcoin Rally Real or a Mirage?
The current Bitcoin rally is likely a bit of each. As painful as crypto winter was, it helped sort out the crypto world. Companies that were doing frankly illegal things are out of business and folks are going to jail. As distasteful as regulations might be in the crypto world, they provide the sort of stability and predictability that most investors want. Spot Bitcoin ETFs fall into this picture of a more predictable and stable Bitcoin world. Thus one would expect to see a slow and steady increase in the use of these vehicles to invest in Bitcoin. And this should result in a slow and steady increase in the price of Bitcoin up to an as-of-yet uncertain price plateau.
The flip side of this situation is that Bitcoin wash trading has not gone away and traders are using great amounts of leverage in attempts to create fortunes in Bitcoin. Both of these are factors that distort the market and mislead other investors. Assuming that Bitcoin keeps going up over the years and assuming that it resumes its huge price fluctuations, what can an average investor do? A common tactic used in such a market situation is dollar cost averaging in which one invests a set dollar amount on a regular basis. When the market is low they get bargains and they do not overspend when the market peaks. Meanwhile remember that part of what you may be seeing with Bitcoin could be a mirage.
