Hello and welcome back.
Last week we looked into Extrinsic Risks of crypto-currency. If you remember the list was:
- Regulatory risks
- Limited Acceptance
- Rug Pulls and Ponzi Schemes
- Economic Risks
- Institutional Investors
We looked into 1-5 last week, and this week I want to tackle the most complicated extrinsic risk: Institutional Investors.
As I said in the conclusion of last weeks article, after learning about these risks you will be at a Phd level compared to other retail investors. While discussing all of these risks is scary, it is vital to properly investing in any asset, and learning about these risks is exactly how you negate them and get to experience the upside of crypto-investing. (this article applies equally to stocks).
Lets define Institutional Investors:
A sophisticated investment firm. They have massive resources, millions or billions of dollars worth of assets under management (AUM), Bloomberg terminal access, and insanely sophisticated forecasting algorithms and metrics.
Think hedge funds, Black rock, and billionaire crypto holders… but mostly the hedge funds.
To explain how these institutional investors put you at risk will require a cursory understanding of how trading assets works on the stock market (and crypto) so you can fully understand how institutional investors manipulate you.
When someone is purchasing a stock or crypto and hoping the price increases, they are going long.
When someone is selling a stock or crypto hoping the price decreases, they are going short.
Its a little more complicated than just “long means up and short means down”, I will explain the basics because it is important to understanding price action (why prices go up and down).
One concept of buying assets (stocks and crypto specifically) I have not discussed yet is Leverage.
If you have $100 to invest and you expect a 30% return on your investment, you have an upside potential of $30. This is a fantastic return compared to the expected 8% from the S&P 500 (especially if that 30% happens in a week), but Its going to take you years to make any kind of life changing gains if you are making $30 at a time!
To get around this limitation, brokerage accounts allow for Leveraged Trading which allows you to borrow money from the broker in order to trade. You owe back the money you borrowed plus fees, but you get to keep the profit you made using their money (similar to a bank loan to buy and rehab a flip property).
It is important to note here: Brokerages like Robinhood, TDAmeritrade, etc. make the majority of their money using "market neutral" strategies. They want to make money regardless of market conditions.
It does not matter to them if your account is going up, or down, they make money every time you trade by charging fees. (yes, even "fee free" brokerages. They sell volume to other firms, and also tend to offer you slightly higher purchase prices and slightly smaller selling prices, this bakes their fees into the asset price, but its still a fee. Looking at you Robinhood).
for example, you can borrow $10,000 from your broker and make the same 30% return trade, But now you have $13,000 instead of $130. you owe back the $10,000 plus some fees and you get to keep roughly $3,000 in profit.
If you fail to pay the broker back on a long position (you borrowed money, and bought bitcoin with it, but the price of bitcoin fell), you will experience what is called a Margin Call. This is when the broker liquidates your account to pay for the assets you borrowed (again, plus fees usually and sometimes interest). This is one of the main ways brokerage accounts make their money, aside from the fees they charge on each transaction you make.
I am not sure if you can tell from how I am talking about it, but I do not like leveraged trading. It exposes you to infinite downside potential, with limited upside potential. this is the opposite of the trading method I recommend. Using leverage is for (or should be for) experienced traders only.
I know this is a lot of technical language but stick with me because this is relevant to the conversation I promise.
The opposite of going long is going short. When an investor believes the price is going to fall on an asset, they can borrow that asset from their brokerage account and sell it. They must repay in this same asset.
For example lets say David, our fictional trader, decides to short bitcoin.
The price is near $30,000 (round numbers tend to have heavy resistance which makes it probable, but never certain, that the price will fall). So David borrows 1 bitcoin worth $30,000 from his brokerage and sells it.
If all goes well, the price drops to lets say $25,000. David must repay the brokerage 1 bitcoin, so he buys 1 bitcoin for $25,000 and gives it back. David just made $5,000 (minus any fees and interest from borrowing the bitcoin).
But lets say David was wrong and the price goes up… and up… and up to $40,000. David owes a bitcoin to his brokerage account, but its going to cost him $10,000 more than he got from selling the borrowed Bitcoin. At some point his account will hit a margin call and his assets will all be liquidated to pay the brokerage back. And that is if he is lucky.
If you go long on an asset with leverage, you borrow Fiat currency (like USD) to buy an asset, and then you return the borrowed Fiat (USD) but you get to keep the profit (USD).
I borrow $10,000 and buy Bitcoin with it, price goes up 30% and I have $13,000 worth of Bitcoin which I sell for USD. I return the $10,000 and I am left with $3,000 of profit from someone else’s money (minus fees).
If you go short on an asset with leverage, you borrow the asset (like bitcoin) to sell for fiat, and then you buy back the asset (Bitcoin) at a lower price and return the borrowed asset (Bitcoin) but you get to keep the profit (USD).
I borrow 1 Bitcoin (in this example lets say its worth $10,000) and I sell it because I think the market will go down in price. If I am correct and price drops to $7,000, I can buy a Bitcoin for $7,000 and return it to my trading broker, and I get to keep the $3,000 difference (minus fees).
Disclaimer: Sorry to reiterate this point so much but It is crucial. DO NOT TRADE WITH LEVERAGE if you do not know what you are doing. Many brokerage accounts allow ungodly leverage levels (100x of your current deposits) especially in the crypto world. you could easily borrow $100,000 and lose ALL OF IT overnight. and you would owe that money back, plus interest. it is incredibly dangerous and I recommend you avoid it like the plague. If you choose to trade with leverage, you are doing so at your own risk.
Long and Short Squeezes.
Institutional investors know that individual investors are using leverage, and they understand human nature they know that these long and short positions tend to be held at Psychological levels of support. Round numbers, SMA’s and EMA’s, Fibonacci sequences, etc. (These are intermediate trading tools that "chartists" use to set price targets for pulling profits, usually with underwhelming success rates.)