How to Lose Money with a Bitcoin Investment, Part 2: The Unhedged Short
As I described in an earlier article, many investors holding Bitcoins naturally look for ways to put those Bitcoins to work, and several worthwhile opportunities are available. But there’s also a whole class of investments which carry quite a potential sting in their tail.
The Unhedged Short
As I mentioned previously, there’s an idea floating around that it’s easy to grow an investment in Bitcoin-denominated terms just by trading in and out of Bitcoin, selling high and buying low. (See “How to Lose Money with a Bitcoin Investment, Part 1: The Easy Money Mantra”.) Unfortunately, using the method reliably — as opposed to doing so by virtue of luck — requires either a magical crystal ball or careful use of derivatives to hedge risk.
But there’s another class of investments incorporating closely related risks in a way that might be not quite as obvious. For a brief time, a gold investment fund was available on one of the Bitcoin exchanges, and a silver fund is still chugging along on another exchange. Each allowed investors to buy an interest in underlying precious metals by paying for shares with Bitcoins. And not long ago, a company in Ohio interested in purchasing real estate successfully tapped the Bitcoin markets for around 770 BTC (roughly $70,000 at current rates) in just 48 hours. Recently, someone has even proposed creating a bona fide equity real estate investment trust (REIT) in Canada, which they hope to set up with an influx of Bitcoins to get them started. Several different people on the Bitcoin forum have pointed out that investments like these can be a bit less than great should the value of Bitcoin appreciate relative to the dollar. More generally speaking, here’s what each of these investments has in common: investing in them amounts to taking an unhedged short position in Bitcoin relative to the investement’s underlying entity. Therefore, they incorporate unlimited risk with respect to appreciation in the value of Bitcoin as expressed in units of the underlying entity.
For example, suppose you invest 1 BTC to buy 1 share of a fund, a share backed by 1 unit of gold. You have, in effect, taken a short position in Bitcoin versus gold. Suppose Bitcoin subsequently rises against gold, so that 1 BTC can now buy 2 units of gold. If you decide to sell your 1 share of the fund, that share which is still backed by 1 unit of gold, you get back only .5 Bitcoins — because it now takes 2 units of gold to buy 1 Bitcoin, and 1 unit of gold therefore buys only .5 Bitcoins. Recovering your original 1 BTC will now take not just the sale of that 1 share of the fund, but also some additional capital from somewhere else.
The story is similar for real estate investments such as REITs, although here the situation is arguably even worse, since an equity REIT is typically leveraged at least moderately, and that debt is apt to be denominated in fiat; so too is the income stream from rented properties (unless properties are only rented to those who can pay in Bitcoins).
Should the value of Bitcoin actually fall versus the underlying entity of one of these investments, naturally the investor will have done well, provided the investment doesn’t destroy value all of its own accord: the underlying entity will now be worth more in Bitcoins than it was to begin with. But should the value of Bitcoin rise, the underlying entity will be worth less in Bitcoins than it was to begin with, and from the perspective of value denominated in Bitcoins, the investor faces the prospect of potentially massive losses.
To put it loosely, such investments are guaranteed to lose money in Bitcoin-denominated terms unless the total returns of the investment in terms of the underlying entity exceed any appreciation in the value of Bitcoin versus the underlying entity. It’s slightly more complicated than this, since in the case of the REIT, the relevant metric is not the underlying entity itself, but the value of that underlying entity as denominated in fiat. And in the case of the silver fund, this particular fund also generates income by writing covered calls against itself. (Now there’s a ‘free money’ scheme just waiting to implode should the value of Bitcoin fall and push the price of the fund above the strike for the written calls.) But the general point remains that making such an investment at all means taking an unhedged short position in Bitcoin, with all the risk that entails.
Marketing-Speak and the Real Market for These Offerings
As far as I can tell, the idea that these types of investments offer a way to “diversify your Bitcoin investments” or a way to “hedge against volatility in Bitcoin” is little more than marketing-speak. Diversifying your Bitcoin investments means allocating a given amount of Bitcoin capital across multiple Bitcoin investments, not reducing your Bitcoin capital and replacing it with something non-Bitcoin. And depending on the rest of an investor’s portfolio, sure, investments like these might actually be used as part of a successful hedging strategy, but promoting them as any kind of hedge in and of themselves seems entirely incorrect to me. (If someone said you could “hedge” your investments in gold by trading gold for shares of the entirely unrelated Company XYZ, would you find the suggestion convincing?)
As far as I can tell, the primary situations in which these investments make sense are those where:
- the investor believes they hold too many Bitcoins and they specifically want to get rid of some, or
- the investor is fully aware of the risk of a rise in Bitcoin versus the underlying entity and accepts that risk as part of a suitably constructed overall investment portfolio.
An investor might have too much capital in Bitcoin and therefore want to sell some for several reasons; perhaps they are convinced its value will fall significantly against something else, or perhaps they acquired large amounts of Bitcoin via mining or at low prices relative to fiat and feel they need to rebalance their overall (i.e., Bitcoin and non-Bitcoin) investment portfolio. However, whatever the reason, the investor in the position of holding too much capital in Bitcoin also has the option of simply converting to fiat currency and moving assets to any other investment at all. The question for the investor then becomes this: out of the entire universe of Bitcoin and non-Bitcoin investments available, why this one?
As for the second alternative, it may well be that many investors fully understand the risk and are entirely comfortable taking on that risk within the context of their overall portfolio; however, the level of apparent controversy over the level of risk suggests that these investors are probably in the minority.
Last but not least, I can understand that someone might believe they have too many Bitcoins but might also feel reluctant or even be unable to convert them to fiat for other reasons; perhaps they live in a country where this is difficult or impossible, or perhaps they would like to avoid questions being raised by government authorities as to how they came to have the money in the first place.
Replacing Marketing-Speak With Straight Talking
Nowhere in this article have I suggested that any of the investments I’ve described are inherently bad investments. For all I know, some or all of them might turn out to be great investments. However, what I think is underappreciated by investors and underexplained by sponsors of these investments is the magnitude and specific character of the underlying risk created by taking an unhedged short position in Bitcoin versus the underlying entity.
In my personal view, those who are marketing offerings like these could probably generate much wider interest in the Bitcoin investor community by simply coming clean on what’s really going on in terms of underlying structure and the risks inherent in unhedged short positions. These investments aren’t for “diversifying” your Bitcoin investments, because they’re not Bitcoin investments at all. They’re for liquidating your Bitcoins and “diversifying” them into something else that has nothing to do with Bitcoins. Their value derives from a different underlying entity altogether, and that value simply gets converted to Bitcoin at the going exchange rate. Nor are these investments for “hedging against volatility” in Bitcoin, except to the extent that simply selling Bitcoins outright and buying something else counts as a “hedge” for that investment.
Talking straight to potential investors about what will happen to the value of their investment under different scenarios of Bitcoin rising, falling or remaining stable versus the underlying entity in question would be a good first move toward attracting larger numbers of investors who are well informed about what they’re buying into.
All material on this site is carefully reviewed, but its accuracy cannot be guaranteed; please do your own checking and verifying. This specific article was last reviewed or updated by Dr Greg Mulhauser on .
https://psychologicalinvestor.com/real-markets/lose-money-bitcoin-unhedged-short-174/