Asymmetric bets are investment opportunities whose potential upside is much larger than their downside.
As an example investing in Bitcoin while it is still in the adoption phase is an asymmetric bet.
Focusing on this kind of investment has a bunch of advantages...
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Playing the odds
Last week we discussed how using leverage is playing a tricky game.
On one hand if things go well you can make a lot of profits, fast and without needing a massive move in the underlying asset.
On the other hand if the market turns against you, losses start piling up equally fast and it is easy to get wiped out unless you have airtight risk management practices (which is doable but hard).
Ask Bill Hwang what he thinks about all that.
Now the reason you turn to leverage is to juice up your returns. The issue is that leverage also juices up your risk.
Asymmetric bets work differently.
By definition those are bets whose potential reward far outweigh the risk. So you already start with a favourable situation.
But let’s be a bit more specific. Why is Bitcoin currently an asymmetric bet?
Well, what’s the potential upside?
The least you can say is that given the current dynamic Bitcoin should be able to catch up with Apple. That would put one BTC at $110k - $120k depending on the day.
If you believe in the digital gold narrative then eventually one BTC should be worth more than $500k. That’s the price level at which Bitcoin matches the physical gold market size.
Add to that a good dose of asset price inflation via endless money printing and you can reasonably make the case that within a few cycles we could see $1m per coin.
So we can say that roughly the potential upside is ranging from 2x in the near future to 10x and 20x for the longer term.
At the same time the larger Bitcoin gets the less likely it will disappear overnight. The risk of losing it all is thus decreasing with adoption.
With a 10x potential return, you can take the risk of losing at most 10% of your portfolio for a chance of doubling its value.
Now with that kind of upside you got yourself an asymmetric bet. Congratulations.
Note that asymmetric bets are not the opposite of leveraged bets. You can very well apply leverage to your asymmetric bets. But the point is that you don’t need to. There are smarter ways to go about it.
For a start as we discussed last week if you are not seeking adrenaline you’ll want to stay away from high leverage plays.
Second keeping your stake to be only a fraction of your portfolio gives you staying power. Whatever happens in the short term you don’t need to liquidate your position. And that gives time for the bet to play out.
Say you have just invested 10% of your portfolio into Bitcoin in February 2020. Comes March and suddenly the price drops by 50%. Well that’s only a 5% decrease in the value of your portfolio. No reason to sweat about that.
If instead you had been leveraged 5x just before the event you’d have been wiped out.
And you know what? With the other 90% of your portfolio that are not invested in Bitcoin you can go and make other asymmetric bets.
At this point you are probably wondering “ok, I understand the idea behind this asymmetric bet thing, but why should I invest 10% of my portfolio on Bitcoin? Why not 5% or 50%?”
To that I’d say: yes, that’s the only real question.
After you have made your analysis of the potential upside the only real question becomes: what percentage of my portfolio should I allocate to this asymmetric bet?
The answer to that depends on what you are trying to achieve. But to keep things simple here is how I like to think about it.
Assume your asymmetric bet has only two outcomes:
You lose your stake entirely.
Your position achieves the desired upside.
Then the percentage allocated to any single bet you make boils down to how confident you are to win.
Say you think that Bitcoin will 10x in 10 years, what probability will you put on that?
The more likely you think this will happen, the more you should bet on the outcome.
If you think there is 0% chance BTC will 10x then obviously you should not allocate any money to that.
If you think there is 100% change BTC will 10x then obviously you should allocate all your money to that.
In real life you’ll almost always end up somewhere in between. And in that case I like to use the Kelly criterion to help size the stake.
I’m not going to bother you with formulas, you can go check Wikipedia for that or Ed Thorp’s essay for more. But in a nutshell the Kelly criterion formula takes the upside potential of the bet together with the probability to reach that potential and tells you how much of your portfolio you should put on this bet in order to maximize your growth.
E.g. if I think there is 50% chance Bitcoin will 10x then the Kelly criterion tells me I should put 44% of my portfolio on that trade.
Ok, instead of staring at a formula why don’t we look at a chart instead?
On the heat map below:
The horizontal axis is the upside potential of the asymmetric bet.
The vertical axis is the probability that you’ll win the asymmetric bet.
Each point on the graph represents the fraction of your portfolio you should allocate to the asymmetric bet based on the probability you’ll achieve the upside.
The darker the point the higher the allocation.
The calculation is done using the Kelly criterion.
Notice that a big zone in the graph is empty.
That’s the zone for which the combination of probability and potential upside is not worth the risk of taking on the bet. In that case you don’t invest at all.
The larger the potential return the smaller this empty zone. Or said differently, the larger the potential return the more it is worth taking the bet even when you think the chances of winning are low.
Now a few caveats:
Of course investment in financial assets typically do not have this binary outcome of winning it all or losing it all. You can do more fancy math to account for that. But this is out of our scope.
In practice you do not know what is the actual probability of getting a winning trade. Most of the time you are only guesstimating so be prudent and err on the side of caution.
Finally the real value of the Kelly criterion comes from making repeated bets. This is not necessarily the best way of choosing your allocation when you are making a very small number of trades. But if you are going to make many asymmetric bets then it is the real deal.
Ok, I’ve been going on for too long already so let me wrap this up.
Chasing asymmetric bets gives you freedom. Freedom to let your trades play out. Freedom to size your positions. Freedom to diversify your trades if you wish to do so.
So don’t pick pennies in front of a steamroller, play the odds instead.
CME Bitcoin Derivatives
Well, well, well. It looks like we are finally getting our breakout above $60k.
When it comes to the CME Bitcoin futures the question is whether this will be taken as an occasion to book profits or if this will get new people to hop on the momentum train.
I have a pretty strong conviction that we are on our way to 6 digits in the months to come. However, if my reading of the Commitment of Traders data is correct, this opinion is not universally shared among the CME traders.
Despite volatility having been on the decline over the past few weeks we are still well below the peak amount of long positions that was established last year. That’s true for retail traders and for the smart money.
Of course the carry trade is alive and well. It is amazing that this arbitrage has been going on for so long. I mean you can still easily capture between 20% and 25% annualized premium with this trade despite this thing going on in full force for more than a year now.
The fact that this premium hasn’t been significantly arbitraged away is a sign of big inefficiencies in the market. Those are most likely due to compliance issues that restrict big players to get onboard and kill the trade.
We’ll see how long that lasts.
One thing is clear at least, there is no particular excitement around the breakout in the futures market. No volume spike, no influx of new positions, it looks like the CME Bitcoin futures market has reached its cruising altitude.
While the options market remains anemic it is interesting to note that the positions are concentrated in two camps:
The protective puts that go as far as guarding against a 50% drop from the current price.
The calls that are pricing BTC to be worth more than $75k in the next 4 months.
Indeed by comparison to the previous months where we typically had more than two thirds of the calls already in the money, this time we are closer to 30% of the April calls already in the money and 16% overall.
That’s a sign the remaining bulls have quite strong convictions regarding where we are heading soon.
That being said, remember that the CME Bitcoin options market is significantly smaller than what it used to be last year. So there is only a limited amount of information to extract from there.
That’s it for today. If you have learned something please subscribe and share to help the newsletter grow.
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:
Click on the subscribe button right below.
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