Bitcoin

Since starting this blog and dabbling in Bitcoin and Ethereum, friends of mine have asked me to hold off with the dollar cost averaging stuff, and go back to the very beginning.

Questions they’ve asked:

• What is Bitcoin?
• Why is it trending now?
• Why should I buy one now?
• How do I get one?
• How should it be viewed in your portfolio i.e. is it an asset?
• How is it different from normal currency?

In this post, I’m going to answer the first question:

What is Bitcoin?

Bitcoin was created by a Satoshi Nakamoto. Nobody knows who he or she is.

The idea was to create a new currency, one that was fully online and digital and that was fully decentralised.

Problems with normal currency

The problems with normal currencies stem from their dependence on third parties.

Normal currencies are controlled by that country’s government and central bank.

So Pound Sterling is controlled by the UK Government and The Bank of England.

Third parties can devalue a currency

The UK Government can print money. Since 2008, they’ve pumped shitloads of new money into the system. This over supply devalues the currency. It buys less now than it did then.

Third parties charge you unnecessary fees

You have to pay fees to move money into other currencies and to move money across borders. Why should you pay £25 to move money to The Philippines in addition to the money you lose on exchanging one currency for another?

Bitcoin aims to solve all these problems. How does it do this?

Well Bitcoins run on something called a Blockchain.

Blockchain is a system or network of ledgers. A ledger is like a register.

The network has the effect of decentralising how the currency operates.

These ledgers record every single valid transaction in Bitcoin that is made. So if I send you a Bitcoin, this transaction is first verified by other ledgers in the system, then the ledgers get synced with the verified transaction. This is truly peer to peer.

We don’t need a bank or institution to tell us that the transaction was made. Other users verify that the transaction happened and then this transaction is recorded on all the ledgers in the blockchain.

There is no need for a bank to verify a transaction. There is no need to use a bank to send or receive money.

I can send money to you in The Philippines peer to peer. I send you a Bitcoin and you receive it. All in minutes or even less. For me to send you money that you could use, you would have to open up a Western Union account, send GBP to be converted to Pesos, then you would have to open up a Western Union account too to receive it. Not so with Bitcoin.

Essential further reading and viewing for ‘What is Bitcoin?’

https://bitcoin.org The official Bitcoin website

https://www.weusecoins.com

https://99bitcoins.com

https://www.investinblockchain.com/what-is-bitcoin

So you want to start building your Bitcoin position?

How should you go about it? Should you just whack your full investment stake in one go?

In this post, I’m going argue that you shouldn’t just whack it all in, and instead I’m going to argue that you should dollar cost average your Bitcoin investment.

What is dollar cost averaging?

This is a way of building a position and making sure that your overall price that you entered a position isn’t too high. (assuming that you want to go long) or too low (assuming that you want to go short).

Example: buying Rolls Royce stock.

If you have £1,000 that you want to invest (i.e. buy/go long), then you could invest that whole £1,000 into Rolls Royce now. Looking at the price in the chart below, the current price as at 14th August 2017 is 904.50p or GBP 9.045.

Now you could put the whole £1,000 into RR at this price.

But what happens if the price starts to fall in the next month, say it drops to 800p? That’s a drop of 11%?

Well, this sort of thing does happen. 11% lower than you got in for? You’re not going to be happy. You’re going to wish that you got in at a lower price. However, you couldn’t have predicted that the price was going to go down anymore than you could have predicted that the price was going to rise following your purchase. But there is a way that you could have lessened the blow of the price drop:

You could have dollar cost averaged your entry into this position.

The easiest way to see this is to imagine that you split your total investable stake (£1,000) into equal chunks say (four lots of £250) and invest at pre-defined intervals (say £250 every week). In our decline case for RR above, this might look like:

Week one: invest £250 at 904p

Week two: invest £250 at 860p

Week three: invest £250 at 835p

Week four: invest £250 at 801p

First step is to calculate how many shares each weekly investment would buy you, then you add up all the shares you bought to arrive at the total RR shares bought.

Then you divide the total investment made (£1,000), by the total number of RR shares (118).

You get an average price of £8.47 or 847p.

Here’s the steps in spreadsheet form:

So thanks for the maths lesson Chan, why does this matter?

Well, if the price is now at 800p (£8.00), then your loss from your average price at £8.47 is less than it would have been had you gone all in at 904p (£9.04).

Fair enough however, the price might have only gone up from 904p (£9.04), and then you’d be sore that you dollar cost averaged with a rising price, therefore reducing off your gains.

This matters even more with Bitcoin and cryptocurrencies

Smoothing out your entry is even more important when trading in volatile things. In our context, volatility refers to the price movements of Bitcoin and other cryptocurrencies.

Look at the price movement from Bitcoin 2017 to date:

The green line above is the price of Bitcoin in USD. Look at the volatility!

From mid-July 2017 to 15 Aug 2017, Bitcoin has risen from USD 2,000 to past USD 4,000. That’s 100% in a month!

You don’t see moves like that in normal stocks like Rolls Royce above.

This extreme of move plus the speed of the move is why dollar cost averaging is so important when building your Bitcoin position.

So if you have £10,000 to invest in Bitcoin (going long), don’t just pump it all in at today’s price. Split it into four £2,500 chunks and invest these in weekly intervals over four weeks and see what your average price for your Bitcoin will be.

Let me know how it goes in the comments below!