Ecoinometrics - April 07, 2021

Leverage...

Leverage is tricky. 

If things go your way and your risk management is airtight then it can greatly enhance your returns.

If the wind turns against you and there is no liquidity to exit the trade you get caught with big losses and margin calls real fast.

So do you really need leverage?


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Leverage

Obviously today’s topic is inspired by the blow up of Bill Hwang’s Archegos fund. For those of you who haven’t read the story here is the tl;dr.

Archegos is Bill Hwang’s family office. They built highly leveraged positions on a handful of stocks. Some of those positions started turning south and the fund was hit by margin calls that they weren’t able to meet promptly. As a result Archegos’ prime brokers liquidated their positions and wiped out the fund.

High leverage and very few positions. I’m getting sweaty palms just typing those words. 

Obviously this worked out for Bill Hwang as he built his family office to $10 billion AUM… until it didn’t. 

That’s the problem with leverage. 

Most investment opportunities give you annual expected returns in the low single digit percent. Some like the NASDAQ 100 will go up to 20% annual returns (at least if you focus on the last 10 years).

Some people are happy with that and let their investments compound over time. 

For many that’s not enough. And in that case they’ll want to juice their returns with leverage.

So let’s do some napkin math. 

You have some cash on hand and you want to make money fast. You give yourself the goal of doubling your money in one year by making one trade.

You have a choice of assets to pick ranging from gold to Bitcoin as well as emerging market stocks, corporate bonds and say the NASDAQ 100.

You gather some data and decide to rank those potential investments based on the average annualized return they generated during the past 10 years.

Once you have those annualized returns some quick math gives you how much leverage you need to apply to your capital in order to double your money in one year.

Here is the result.

Bitcoin has averaged 230% annualized returns over the past 10 years. So if we expect to get that much in the year to come then we do not need any leverage to double our money. 

I like that.

If you bet on the NASDAQ you already expect to have to use a 5x leverage to generate 100% return in one year.

After that things quickly get out of hands. Investing in bonds will require a 20x leverage. Gold didn’t do so well in the past 10 years so you’ll need 66x leverage to hope to achieve your goal…

Now if you like to live your life on the edge you’ll discard picking up Bitcoin. That would make your life too easy. 

Instead you choose another asset. If you are lucky everything is fine. But what if you aren’t? How fast can you lose your money on that trade?

One way of looking at that is to ask how big of a downside move would wipe out half of your capital?

Here is the answer.

Yep, a mere -10% move against you will wipe out half of your starting capital if you are using a 5x leverage.

If you had picked Bitcoin instead it would have taken… well actually you couldn’t have lost half of your starting capital with the Bitcoin bet simply because you didn’t even need to invest half of it to reach your goal.

Now this is obviously an unrealistic scenario I’ve come up with here.

For once average annualized returns are probably a bad predictor of any outcome on a one year time horizon. You’ll probably need a longer time horizon to let those trades play out. 

Second if the trade goes in your favour someone reasonable will take profit and reduce their exposure before things blow in their face. Although many people won’t… proper risk management is definitely mandatory when you play this kind of game and I’m totally ignoring this aspect here.

But the point I’m trying to illustrate here by singling out Bitcoin in the previous charts is that there are two types of bets you can make:

  • Bitcoin is an asymmetric type of bet. The upside is so large that there is no need for leverage to generate great returns. As a side effect that means lower risk on your portfolio.

  • The other assets listed above require you to play with leverage in order to achieve the same absolute performance as an asymmetric bet.

Spoiler alert, at its current valuation Bitcoin remains an asymmetric bet. If you are sold on the digital gold narrative there is still 10x growth for BTC to match the market size of physical gold.

Today’s example shows why you might want to avoid leverage. Tune in next week to see what are the advantages of asymmetric bets when it comes to risk management…


CME Bitcoin Derivatives

What are the CME traders up to these days? As usual the answer is not much new. 

Take the retail traders and zoom out a little bit. Starting after the crash of March 2020 we’ve had:

  • First a rise in the amount of long positions from traders betting on a rebound.

  • Then when it looked like the rally stalled everyone decided to take profit. Consequently the number of long positions dropped.

  • Afterwards we have the second phase of the post-halving rally and things get a bit messy. But in trends you have another rise in the long positions. 

  • Then since the start of the year it looks like things have topped out. More of the longs are getting closed as traders are surely taking profit on their trend following positions and working on shorter time frames.

So to me it looks like the CME traders are unsure about where we are going next.

I'm not sure such caution is really warranted. On-chain data has been showing that there are less Bitcoins available for sale on exchanges. At the same time it is unlikely that institutional investors are done with BTC. So demand being there and supply getting tighter, you'd think that this is another indication the post-halving bull market is not over.

Talking about institutional investors, on the CME the smart money is not taking sides. They continue to run the futures vs spot arbitrage that has worked well for over a year now. That's a neutral position, so as long as there is a premium in the futures they are printing money.

With the Easter weekend there wasn't  much activity to expect. We got exactly that.

The options market is still struggling with liquidity. There is no reason for this to change so I'd expect the open interest to shrink further next month. 

We'll see about that.


That’s it for today. If you have learned something please subscribe and share to help the newsletter grow.

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Cheers,

Nick


The Ecoinometrics newsletter decrypts Bitcoin’s place in the global financial system. If you want to get an edge in understanding the future of finance you only have to do two things:

  1. Click on the subscribe button right below.

  2. Follow Ecoinometrics on Twitter

Done? That’s great!