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Disclosure: I currently have around 700 bitcoins, would be buying more on dips.

Given below is the Google trend graph showing the interest in bitcoin-related search items at Google from Jan 2010 to April 2013. Interestingly, those tracking bitcoin prices will find that the bitcoin price curve for the same duration is exactly the same!

At the same page on Google trends you can also see the geographies from where most search queries are coming from.

Evidently 2 events triggered the renewed interest in bitcoin. The first was the clarification by Financial Crimes Enforcement; the market considered this as proof that federal agencies are now formally recognizing these so called virtual or math based currencies. The second event was the freezing of business and retail accounts by Cyprus, which piqued the public's interest in currencies which are backed and controlled by mathematics and computing rather than governments.

In this article, we will not go into the pros and cons of using bitcoin as a currency, you can find tons of articles on that at Google. We would rather focus on what are the investment and trading opportunities available to investors in bitcoin.

Lots of comments have been made on the bitcoin bubble; comparisons have been made with the 17th century Dutch tulip bubble. In bitcoin's brief life of 2 years, the market has already witnessed at least 2 bitcoin 'bubbles.' The first was in June 2011, when the price rocketed from less than 2 USD to 31 USD within a couple of months before settling back to around 2USD five months later. See the chart below. Rationally, nobody should have bothered about bitcoin after the first 'bubble'.

After all, nobody ever paid a fortune for a tulip bulb after May 1637 when the bubble finally did burst.

Even after the recent price crash, the volumes for bitcoin trading are strong. In fact, the volume at MtGox now is even higher than it was at the 9th of April when the prices peaked at above 240USD.

In my humble opinion, bitcoin is no bubble but a novel and a genuine asset class, the valuation of which is not yet clear. Ignoring this asset class will be very expensive as bitcoin and other peer-to-peer-ledger-accounting currencies backed by maths and computing are here to stay.

Here are the top 10 reasons to support my hypothesis:

  1. It's a very addictive nerdy concoction of computing, cryptography and dogma-free-economics which is hard to let go once tasted. Investors and traders will keep returning to this market despite all market inefficiencies (if any)
  2. The underlying digital economy and the user base which is comfortable using bitcoin as money is only going to increase
  3. Traditional financial investors in gold (at least in Cyprus) will divest some of their assets into bitcoin. It gives them all the benefits of gold (except physically touching it) and amazing portability (carry it in your thumb drive, or just email it to your relatives in India)
  4. Bitcoin price modelling will be one of the most exciting fields which will come up. This would require quants to dabble in cryptography, hash rates, ASICs, and perhaps quantum computing too. Many exotic hedge funds and even large investment banks are likely to use their proprietary models for creating OTC markets around bitcoin. Bitcoin funds are already in offering. It is heartening to note that the fund manager is a systems developer and a mathematician, more power to the IT folks
  5. In case valuation models for bitcoins fail, the resulting realization that they have no inherent value and not backed by a government would still turn out to be not so bad, because then true traders can focus only on the LOB (Limit Order Book) characteristics rather than worrying about fundamentals
  6. Tax avoidance (for now) while the governments struggle to makes sense of all this. This would attract some investors
  7. As trading volumes increase and more market makers come into market, liquidity is bound to increase and volatility will fall. With a thriving exchange, bitcoins are as good as any other currency as long as they can be converted at current exchange rates. Think of them as IOUs or traveler cheques
  8. I have been tracking bitcoin since its inception, earlier it was just like a select club to which you wanted to be a member in order to satisfy your intellectual ego. However, now it seems that the interest has tipped over to other side into the mainstream attention. It has become a very large virtual online casino where everyone is trying to outsmart and out-speculate others. When select clubs become mainstream, billions usually follow, think Apple, think Facebook
  9. New better trading platforms will emerge which will allow even more flexibility, such as shorting bitcoin to the traders
  10. Anonymity - Until the government outright bans trading in bitcoin, the market is likely to find inflows from investors who seek complete anonymity while trading. Most exchanges will allow you to trade in bitcoin vs. USD (or any other currency) with a simple email based registration. (With no KYC norms, this is likely to also attract inflows from illegal areas such as drug trafficking, racketeering, and terrorist financing)

So what are the ways in which bitcoin can be traded to generate alpha?

Exchange arbitrage - Bitcoins are traded today in almost all important currencies on at least a dozen exchanges. The largest exchange with close to 75% market cap is MT. Gox. The other notable exchanges are:

  1. BTC-E
  2. Bitstamp
  3. Bitfloor
  4. Bitcoin-Central

Between these exchanges there is always an arbitrage available which can be played (see the screenshot below), for example at the time of writing this article, one could have bought bitcoins at USD 79 from bitstamp and sold it at USD 82.5 on mtGox, an instant return of 4.4%!. Of course there are execution slippages, particularly as both the sites still offer only screen based trading. However, they do publish the full order book online; with a little investment in script programming one can develop an application for auto punching of orders on the screen too.

Please note that that there are exchanges which do offer full electronic trading. For example, Bitfloor offers full FIX gateways for market data and order management.

The trading fee schedule lies about .6% which is far lower than any other asset class through any broker. Money transfer between all these exchanges is a 10 minute affair as all you have to do is to transfer your bitcoins. You will never need to open separate bank accounts for any of these online exchanges

Currency Arbitrage: Since bitcoin is traded in almost all major currencies, the cross currency arbitrage can also be played. Custom development would be required to develop links to a currency trading platform from your bitcoin trading excel sheet for executions without slippage

Market making - the LOB (Limit Order Book) is just like that for any stock book with decent spreads. Just providing liquidity to the market will allow traders to earn a reasonable income. One can build additional complex order types such as stops, pegs and tick sensitive orders with any traditional quoting and market making application

OTC options contracts - do you fancy exotic options? Post your bids and offers at this site.

Go long: Some of the smartest investors are long bitcoins; build your portfolio by taking long positions whenever the market tanks.

Recommendation

The trading volumes around bitcoins continue to be strong and price volatility is likely to come down once more market makers enter the picture. Take small incremental positions in this truly geeky asset class at every dip. For minimized risks consider day trading in bitcoins, strategies could be exchange/currency arbitrage or pure market making.

Do not start trading in bitcoins until you have figured out on how to install the bitcoin wallet on your desktop and the way in which you can transfer you bitcoins from the exchange back to your wallet..

Disclosure: I'm long bitcoins. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: 10 Reasons Why Bitcoin Is Going To Stay Around And How To Trade It