With the recent debacle involving FTX, the second largest exchange in crypto, I think it timely to review and emphasize the counter-balancing role that risk management must play in our careers as speculators. Nor is this ad hoc, or after the event, but a re-appraisal of the principles that were first espoused in the 'Fool-Proof System'. Further to this, the intention here will be to make more explicit what these principles might entail for your actual trading account with its exposure to the market. If, as I believe, the market is not dead, this will serve to put us in good steed going forward. Keep in mind, that near all retail gets burnt by the market on first entry. The point, insofar as one stays in the market, is to learn from the experience. As the saying goes, ‘Fool me once, shame on you; fool me twice, shame on me’. The aim of this article is to outline the way in which your trading account can also function as a ‘balance sheet’, where risk is completely internalized and managed in a more practical manner. I’ll first review why risk management must be central to our speculations, and then go on to describe how this can actually be managed by ourselves [insofar as we remain in an unregulated market].
1] The Centrality of Risk Management [Review]
Central to speculative activity should be the understanding that markets are not fundamentally rational [as in efficient.. the efficient market hypothesis] but also irrational insofar as they are based on speculation involving mass human behavior in all its aspects. Market behavior is just as often motivated by utterly irrational factors as it is by rational ones. Indeed, for the speculator, human behavior can almost be said to be the macro… something I touched on in 'Market Behavior':
The savvier speculator becomes a more discriminate buyer. As opposed to a sole focus on the fundamentals, this breed of buyer has more of a bi-focal view on both the rational fundamentals AND the irrational exuberance that comes with speculative markets. With a healthy dose of skepticism on the one side, they will look askance at the more exuberant of narratives whipping the more gullible into a buying frenzy. That said, they’ll also on the other side maintain a healthy dose of confidence and keep an eye on the more sober of narratives outlining the case for a continued and more modest trend upward. What you have here is something of the balancing act of the agile high tight-rope walker with the opposing forces of speculation and fundamentals on contrary sides…. not to mention risk below and fame and fortune beyond.
It is due to this irrational aspect of the market - leading to radical volatility, booms and busts, and ‘speculative episodes’ - that one is obliged to manage risk. It is only with the failure of risk management that one can get too heavily caught up on the wrong side of the trades in the inevitable bust that comes after the boom. An equal and opposite reaction can then set in [both in the market and in the trader/ investor’s own psychology], where the previous uber-bullishness comes to be matched by a present uber-bearishness. Where one was first too reckless, one now becomes too cautious. And what can get lost in this equation is the contrarian outlook by which the savvier trader profits, one that is often counter to the prevailing view.
With the dynamic of speculation deliberately front and foremost before us in our interpretation of the phenomenon that is Bitcoin, I sketched this account for the more seasoned and skeptical investor. It was to also function as a ‘stress-test’ of sorts for those that would otherwise succumb to unbridled enthusiasm in the boom phase.
The way forward here I think is to start thinking of Bitcoin as a series of speculative episodes, or mini-bubbles. What strikes the investor on first viewing the chart is not only the pattern-like structure to it, but the way in which the increases [the speculative episodes] heavily correct. Where assets are simply in a bubble, prices are known to keep inflating on the manic episode without solid corrections and until the price becomes unsustainable. Indeed, any proper correction would serve to ‘pop’ the bubble. In Bitcoin instead, as is depicted in the chart below, you see a solid correction after a manic episode, followed on again by a solid correction after a manic episode. One could indeed say you have a series of something that looks likemini-bubbles, but then not bubbles in so far as each episode in the series heavily corrects, where the previous ‘bubble’ is effectively ‘popped’. It is quite something else in the aggregate. Where the speculative excess culminates in a series of punctuated peaks, the corrections serve to provide a baseline of sorts, with this baseline representing a logarithmic growth curve [something that begins with explosive growth but that plateaus over time]. What’s striking here about this developing log growth curve, is that this principle is also a well-known force of nature. It’s as if Bitcoin price were not completely and utterly random riding on the whirlwind of human emotions, but following some rational rule or another, or some trend. And of course, it’s this longer term trend that is going to interest investors every day of the week.
Yet once again human behavior [and the psychology under-girding it] comes to the fore. Further to this, it interesting how we can be perfectly aware of risk management in theory, at a superficial level, and yet fail to put it into concrete practice. We may pay lip service to risk, and yet we get swept up in the mania. And this is perfectly understandable given we are social animals… we tend to congregate in groups. In of itself this is fine, but not so fine when the social instinct is siphoned off into highly speculative markets. For then, from the contrarian perspective, one becomes very vulnerable to risk. We may think there is safety in a herd, but the very opposite is the case in ruthless markets [the trawling net catches the whole school as opposed to the primary predator catching its single prey]. Just as there is much opportunity, there is also much misfortune [despite the hype]. The savvier trader/ investor needs to be nimble-footed, to be on the fringe, with a foot in both worlds of risk and risk aversion.
As those who have been following me for some time now will no doubt be aware, I’ve sought to portray this balancing of both risk and risk aversion in my foundational article 'The Fool-Proof System'. The article describes the principles involved, but I wonder if those ideas could be further illustrated in a more practical manner… in something like what follows.
2] Become your own Balance Sheet
We are all familiar with the notion of becoming your own banker. But perhaps that is only the beginning of risk management, where a fundamental tenet of which is one of diversity. It is not enough to hold a single position in anything no matter how robust and alluring it appears to be.
First of, all financial assets [yes, even forms of liquidity] need to be balanced against real assets [tangible stuff, the possession of which is enjoyed in real life]. If ‘all in’ one at the expense of the other, you are overly exposed one way or the other - lack of liquidity with no access to cash funds, or too much exposure to financial assets [currencies now trade freely on markets and in an ultimate/ macro sense can be considered commodities/ assets]. These extremes are also symptomatic of the miser on one end of the spectrum, and the profligate on the other. Balance/ moderation between the extreme options is the key here.
Second, further diversity is required in financial assets. If [as most readers here will be] those financial assets equate with Crypto, then a diverse approach is required as far as risk management goes. Remember, this is the willful and radical entertainment of risk/ uncertainty, where all enthusiasm for the ‘fundamentals’ is for one moment put to one side. Coming back to the idea of a balance sheet [systematically managing your own risk] , in the world of Crypto, where this is your holding/ trading account, this would involve cash/ stable coins on one side of the balance sheet with your exposure to Bitcoin and alts on the other. Keeping balance in mind, as your trades and positions increase in terms of cash value, they are to be skimmed off in order to maintain the balance… in the realization of profits along the way.
Further to this, and keeping the first balance between real assets and financial ones in mind, not only are profits to be skimmed off from alts into stables coins, to restore the balance of your holdings, but so too is cash to be skimmed off from your trading account altogether [your exposure to the whole Crypto space, centralized exchanges included] in order to account for systemic risk. These skimmed profits are best directed into real assets [and real wealth] in my opinion. If some such procedures were followed, whereby one continually practiced a policy of drawing balances [and drawing from balances], then come what may, one can weather the storm. If you’ve already conducted your own ‘stress-test’ then if/ when the stress of a potential systemic meltdown in the space actually unfolded you’d get through without getting rekt. On a balanced sheet, you would no doubt get a bloody nose in the worst-case scenario, should it eventuate, you’d also survive to fight another day. The added bonus of this self-inflicted stress-test [when the going is good] is that it should create a next to near anxiety-free condition in the trader/ investor. The point here is one of calculated risk and skill just as can be found with the high-wire tightrope walker…. a more appropriate picture of the grounded trader/ investor in contrast to the high-flying Icarus.
The balance sheet epitomizes negative capability, the ability to maintain more than one idea in mind at one time. The thesis and the anti-thesis are thought together [synthesis]: the thesis is the volatile investment to which you’re exposed; the anti-thesis is the stable cashed-up counter-party position to that exposure. In operating your own internalized balance sheet [aka hedging], you are also becoming your own fully liquid counter-party to the risk you take on. And in this sense, one can then truly say that they have become their own bank. Nor does this simply mean that you have to be risk averse. In avoiding the simplistic binaries of risk on/ risk off, or bear/ bull, you stay ahead of mass sentiment such as the contrarian is like to do. It’s really a case of just managing that risk as opposed to giving free reign to it on the one hand, or strangling it on the other. It’s all about restraint. As for the next large hedge fund that no doubt will rise from the ashes, how about they name it Icarus, in order to keep ever-recurring hubris before our minds.