Bitcoin Valuation

[Chainsaw]

The whole point of the Speculation forum - trying to make some sense of the market.

Why does Bitcoin have the value it currently does?
What will Bitcoin's value be tomorrow?

Something I think we all fall victim to, at least occasionally, is to miss the forest for the trees.  We assess its value based on just one or two pieces of information.  Bitcoin's value is determined by a free market. There are many moving parts, some pushing the value up, while others push the value down. Any complete valuation of Bitcoin needs to take all these factors into account.

It's all about fear and greed.  Please note - this remains a gross oversimplification.  The main focus here is to define a simple paradigm, a structured way to look at Bitcoin when trying to assess its value.  I would encourage everyone to tailor this model to themselves, most importantly because your belief in the power of certain market forces will invariably be different than my own.

Fear  - Belief that Bitcoin's future price will be lower than the current price.
Greed - Belief that Bitcoin's future price will be greater than the current price.

Let's say you have been watching market prices, and each day for the past 20 days, the price has gone up $1.  There's a good chance you are going to expect it to go up $1 tomorrow.  You're basing that belief on activities that have taken place within the market. That makes it a technical indicator.

Now let's say you just read an article in your Bitcoin news feed - "Amazon to Start Accepting Bitcoin".  If you're at all like me, you're buying up bitcoins with every spare penny you've got, the first instant you can.  You'd be basing your belief on a news event that you think will lead to greater acceptance (and therefore demand) of Bitcoin.  This would be a fundamental indicator.

Please bear with me as I make up a few terms, so that we can talk about the fear- and greed-based fundamental- and technically-based indicators.  Then we'll be able to put it all together.

Fundamental Indicators

Legitimacy (Greed) - Confidence in Bitcoin's long term future, acceptance, and adoption.
Nullification (Fear) - Fear of illegitimacy (i.e. one or more countries defining Bitcoin to be illegal)

Technical Indicators

Oversold (Greed) - Belief that the market's valuation of Bitcoin is too low, and will correct upwards.
Overbought (Fear) - Fear that the market's valuation of Bitcoin is too high, and will correct downwards.

Let's walk through an example to put this all together.

It's March 18, 2013. The article I've been waiting nearly two years for shows up - the Treasury has just announced that it will regulate Bitcoins.  The significance to me is in what they did not say. They did not say they were coming after it. Implicitly, they said they accept it. The Legitimacy indicator has just skyrocketed.  Viewing Bitcoin purely as a commodity, the likelihood of its future value going to zero has just been signicantly reduced. The valuation of Bitcoin has increased.

Time to do due diligence, and scan over each of the four kinds of indicators. Are there any other new forces that might counterbalance the news? Other news that might magnify the value gain? Going through one by one...

Legitimacy - If I remember correctly, a small handful of other positive news stories had broken around this same time.
Nullification - No new threats.
Oversold - The rally was underway, but was controlled, and already looking stronger by the day.
Overbought - No new threats. (The previous all-time high had been cleared, and the order book was solid.)

New Price = Current Price + Fear Adjustment + Greed Adjustment

Factoring in all the variables, there are new, strong upward forces, with no new downward forces.  Everything pointed to an upturn.  I went all-in, and committed to buckling in for the ride.  And whaddaya know, the surge to $266 commenced.

I love the quote, "Plans are worthless, but planning is everything."
Was my assessment correct? I'll never know. Maybe I got lucky, and the price bump was entirely due to the new mining rig surge, or Cyprus, or some other factor I'll never understand.
What matters is that you do it. Then afterwards, reflect on your decision, and learn from it.

This is a great first step towards moving out of emotional investing, and towards structured, findings-based decisions. As you do this more, you'll hone your trading instinct. Learn what you overreact to, relative to the market. Figure out where you tend to see the value ahead of the market. These findings will grow your skill (and gains) as a trader.  It's hard work...but it can sure be worth it. 

[1714067067]

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[1714067067]

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[BTC Books]

Hey!

I see what you're doing here:  you're trying to inject rational thinking into the bitcoin community.

WTF is wrong with you?

 

₊₁

[Qoheleth]

Nullification (Fear) - Fear of illegitimacy (i.e. one or more countries defining Bitcoin to be illegal)

There's more to it than government prohibition, I think. Fear of illegitimacy would include anything that would fundamentally get in the way of using coins you have bought. This includes bugs and market problems, whether people in the future will actually be taking BTC for things you care about, whether you'll be able to transfer two dollars without waiting two days for it to get confirmed...

[Chainsaw]

Fear of illegitimacy would include anything that would fundamentally get in the way of using coins you have bought. This includes bugs and market problems, whether people in the future will actually be taking BTC for things you care about, whether you'll be able to transfer two dollars without waiting two days for it to get confirmed...

I 100% agree with you, Qoheleth.  I struggled with trying to keep it simple without glossing over major points.

I think of the fundamentals as being predictors of greater market adoption, usage, acceptance. These things will lead to a greater number of bitcoins being transacted each day - increased demand.  And supply, on a relative scale, remains largely unchanged.

Going in the opposite direction - you gave a great example of why you would use different considerations for different time scales.

When making decisions for my long-term funds, I would be holding the long view - what are the present risks of Bitcoin completely failing? What indicators are there that widespread adoption is imminent? What is the vector, up or down?

When making decisions for my short-term funds, I would be considering fundamentals more like you are mentioning.  What effect has Mt Gox's crashes had? How do I want to respond the next time one occurs?  What do I think will happen to prices now that Mainstream Market X has opened, and allows for shorting?  These things will affect price on a shorter timeframe, but then equalize into the price long-term.

[Chainsaw]

On the fundamental side, my take is:

• Decrease from the Coinlab/MtGox lawsuit fiasco (short term if resolved amicably, otherwise, permanent small-to-medium downward adjustment)
• Decrease from recent regulation stories (short term, mostly fear-based, no new legitimate threats)
• Increase from China's increased awareness/adoption (short term large, long term based on total money that remains in market)
• Increase from favorable statements/awareness by Bill Gates, Eric Schmidt (small)

Technically speaking, I think we've got one more downturn, then it's time to strap in, and hold onto those Bitcoins.

I'd welcome other's opinions on overall valuation, and where they feel it stands today, as compared to recent past.

[wobber]

On the fundamental side, my take is:

• Decrease from the Coinlab/MtGox lawsuit fiasco (short term if resolved amicably, otherwise, permanent small-to-medium downward adjustment)
• Decrease from recent regulation stories (short term, mostly fear-based, no new legitimate threats)
• Increase from China's increased awareness/adoption (short term large, long term based on total money that remains in market)
• Increase from favorable statements/awareness by Bill Gates, Eric Schmidt (small)

Technically speaking, I think we've got one more downturn, then it's time to strap in, and hold onto those Bitcoins.

I'd welcome other's opinions on overall valuation, and where they feel it stands today, as compared to recent past.

Thank you for sharing. But how do you quatinfy Fundamental indicators?

[UltimateReaper]

Good thread. Thanks OP. However, what about chance variables?

The unthinkable happens quite often I'd say.

[SAQ]

Well, the market considered it to be very bad news the possible regulation by the commodities chamber two days ago.

[Chainsaw]

Thank you for sharing. But how do you quatinfy Fundamental indicators?

That’s the tricky part. Bitcoin is uncharted territory, so we’re making it up as we go.
If you look at existing markets, they have precedents.  Making up some numbers, let’s say a company starts releasing Widget X. They expect it will earn an additional $1,000,000 per year.  In general, the value of that company can be assumed to have gone up 10 times that annual revenue, or $10,000,000.  Different sectors have multipliers that may be higher or lower, but news generally prices in the same way.

The important thing is to realize, in this equation, we are the tail, not the dog.  Here’s a recent example.  I saw a few mentions about the Japanese banking holiday.  The largest holiday for them of the year!!! Funds won’t be available! My knee-jerk reaction to this was, wow, this could dry up funding, cause a short term dip. Thinking more deeply…Japan is one country. And we know from other data that they do not represent a significant percent of bitcoin users.  So while this news will be significant to anyone in Japan, it is very unlikely to affect the overall market value.

Some fundamental valuations are cut and dry.  All other things being equal, if you double the amount of users/money using Bitcoin, then the value of a Bitcoin will double.  Take this, and put it up against the recent news re: China.  We have seen an increase in wallet downloads in China following the news story.  We have seen a surge in mining. These are the facts. The rest is speculation.  Absent facts, you speculate, and live with your right-ness or wrong-ness.  Will Bitcoin be used to store corrupt money of officials in China? No one knows for sure.  But we do know this: There is alleged widespread corruption at this level, and the amount of money we’re talking about is large.  I can see this news potentially helping bitcoin. Possibly on a massive scale. On the other side, I don’t see it as posing any risk to the value of bitcoin.  I’m not terribly concerned about putting a specific number on this, because my plan is the same either way:  Close any positions in the next 1-10 days, then plan on holding bitcoins until I can look at the impact with the benefit of hindsight.

As time passes, these valuations will start to have precedents, and become more predictable.  Right now, no one knows, so the market defines, then redefines these impacts.  What is true today won’t be true tomorrow.  As long as we learn from our mistakes of yesterday, our valuation tomorrow will probably be more accurate. In my mind, that’s the best you can do – create a self-correcting system of valuation, and stick to it. Incrementally improve. Profit.  It’s enough to make an underpants gnomes jealous.

[wobber]

Thank you for sharing. But how do you quatinfy Fundamental indicators?

That’s the tricky part. Bitcoin is uncharted territory, so we’re making it up as we go.
If you look at existing markets, they have precedents.  Making up some numbers, let’s say a company starts releasing Widget X. They expect it will earn an additional $1,000,000 per year.  In general, the value of that company can be assumed to have gone up 10 times that annual revenue, or $10,000,000.  Different sectors have multipliers that may be higher or lower, but news generally prices in the same way.

The important thing is to realize, in this equation, we are the tail, not the dog.  Here’s a recent example.  I saw a few mentions about the Japanese banking holiday.  The largest holiday for them of the year!!! Funds won’t be available! My knee-jerk reaction to this was, wow, this could dry up funding, cause a short term dip. Thinking more deeply…Japan is one country. And we know from other data that they do not represent a significant percent of bitcoin users.  So while this news will be significant to anyone in Japan, it is very unlikely to affect the overall market value.

Some fundamental valuations are cut and dry.  All other things being equal, if you double the amount of users/money using Bitcoin, then the value of a Bitcoin will double.  Take this, and put it up against the recent news re: China.  We have seen an increase in wallet downloads in China following the news story.  We have seen a surge in mining. These are the facts. The rest is speculation.  Absent facts, you speculate, and live with your right-ness or wrong-ness.  Will Bitcoin be used to store corrupt money of officials in China? No one knows for sure.  But we do know this: There is alleged widespread corruption at this level, and the amount of money we’re talking about is large.  I can see this news potentially helping bitcoin. Possibly on a massive scale. On the other side, I don’t see it as posing any risk to the value of bitcoin.  I’m not terribly concerned about putting a specific number on this, because my plan is the same either way:  Close any positions in the next 1-10 days, then plan on holding bitcoins until I can look at the impact with the benefit of hindsight.

As time passes, these valuations will start to have precedents, and become more predictable.  Right now, no one knows, so the market defines, then redefines these impacts.  What is true today won’t be true tomorrow.  As long as we learn from our mistakes of yesterday, our valuation tomorrow will probably be more accurate. In my mind, that’s the best you can do – create a self-correcting system of valuation, and stick to it. Incrementally improve. Profit.  It’s enough to make an underpants gnomes jealous.

Thank you again. I enjoyed your posts. Let me know your positions went. and good luck making some money.

[BTC Books]

The important thing is to realize, in this equation, we are the tail, not the dog.  Here’s a recent example.  I saw a few mentions about the Japanese banking holiday.  The largest holiday for them of the year!!! Funds won’t be available! My knee-jerk reaction to this was, wow, this could dry up funding, cause a short term dip. Thinking more deeply…Japan is one country. And we know from other data that they do not represent a significant percent of bitcoin users.  So while this news will be significant to anyone in Japan, it is very unlikely to affect the overall market value.

I enjoy your deconstructions of market input - but you missed the boat on this one.

The point of the assumption in re Japanese holidays having an over-all depressing effect on liquidity is this:  MtGox is the majority of the trading market > MtGox is a Japanese company with a Japanese bank = difficulty in money transfers being finalized = temporary low liquidity.

[Chainsaw]

BTC Books - 100% agree. I completely missed the point on this one.  I'm glad it didn't bite me. 

Thanks for the correction. You've helped me again improve my process.

I never ran this potential fundamental news past my Trading Buddy (https://bitcointalk.org/index.php?topic=181076.msg1890117#msg1890117).
Because, on my own, I had brushed it off as inconsequential.  A false negative!

In the future, I should probably validate those with my trading partner.  Maybe 99% of the time it will yield no change in strategy, but in cases like these, where I was forgetting a crucial detail, it could dramatically change decisions.

Thanks again!

[RationalSpeculator]

Chainsaw,

Thank you so much for your valuable post. I enjoyed it very much.

I also read your other posts. I like your trading buddy idea as well as your free wealth consulting advise, as well as your buddy's bitcoin rally song

I'm sorry for the negative responses you got on the free wealth consulting offer. Some people are just plain rude and acting out. I learn to use the ignore button for those. It makes the experience here more pleasant.  

I hope to read more from you!

[UltimateReaper]

Well I never got a reply so let me rephrase: Is there any way to quantify risk over time?

The chance of something drastic happening like GOX getting DDOSed or something of the sort increases over the time doesn't it? Therefore the longer a price has risen or had steady growth doesn't the chance of a crash or downturn increase? Or is that faulty logic?

[evoorhees]

Hey!

I see what you're doing here:  you're trying to inject rational thinking into the bitcoin community.

WTF is wrong with you?

 

₊₁

LOL

[evolve]

*Well thought out post*

Good stuff. The speculation forum needs more posts like this.

[Chainsaw]

Thanks for the kind words, all.

Well I never got a reply so let me rephrase: Is there any way to quantify risk over time?

The chance of something drastic happening like GOX getting DDOSed or something of the sort increases over the time doesn't it? Therefore the longer a price has risen or had steady growth doesn't the chance of a crash or downturn increase? Or is that faulty logic?

Reaper,

I honestly don't know whether the risk increases as a function of time.  My guess would be yes. 

I tend to think of that risk as being more strongly, positively correlated to the value of Bitcoin.  If the value of Bitcoin increases tenfold, a criminal has ten times as much to gain by somehow pulling off the same theft.  In the end, it serves as a balance. Price goes up, likelihood of negatively perceived event goes up, price finds new, lower equilibrium after pricing in the new news.

While I think that's how things work, I don't really base trading decisions on it.  I think by definition, these events are reactive.  You make or lose money on these events by assessing what the market will price the news at, more accurately or more quickly than other traders.

[UltimateReaper]

Thanks for the kind words, all.

Well I never got a reply so let me rephrase: Is there any way to quantify risk over time?

The chance of something drastic happening like GOX getting DDOSed or something of the sort increases over the time doesn't it? Therefore the longer a price has risen or had steady growth doesn't the chance of a crash or downturn increase? Or is that faulty logic?

Reaper,

I honestly don't know whether the risk increases as a function of time.  My guess would be yes. 

I tend to think of that risk as being more strongly, positively correlated to the value of Bitcoin.  If the value of Bitcoin increases tenfold, a criminal has ten times as much to gain by somehow pulling off the same theft.  In the end, it serves as a balance. Price goes up, likelihood of negatively perceived event goes up, price finds new, lower equilibrium after pricing in the new news.

While I think that's how things work, I don't really base trading decisions on it.  I think by definition, these events are reactive.  You make or lose money on these events by assessing what the market will price the news at, more accurately or more quickly than other traders.

I see. Thank you for this insight. I suppose there may be some risk mathematics out there, but short term evaluation is probably best when trading. I'll keep learning more and working at this on my own.

[wamatt]

The whole point of the Speculation forum - trying to make some sense of the market.

Nice start Chainsaw, it's encouraging to see an attempt at a rational framework. I don't expect any of us are on top of it all, but maybe together we can get better. So we agree greed and fear drives markets. I would add supply and demand too are another way to view it. IOW there can be demand without greed. Let's say I want to buy a house, and that owner has said he will only sell it to me in BTC. I now need to convert USD to BTC to buy the house. That's demand driven purchasing. While this scenario currently probably does not represent much volume, that may change in the future. FWIW SR was/is significant in this regard.

So moving on, if we accept the formula:

BTC price = Fundamentals + Technicals (i'm not sure the equation concept itself makes sense in this context, but lets ignore that for now).

An issue here is that Fundamentals are not news articles. They are facts. Let's look at one of the most accomplished fundamental macro investors in the world, Ray Dalio of Bridgewater. The company has about 1000 employees who's job it is to research the fuck out of claims and opinions, in order to turn them into facts. He then takes these facts and models them against each other to create a blueprint for how the global economy works.*

*(If you can do that over 30 years, you too could be sitting on a $100b hedgefund)

So to be more specific. Fundamentals might look like this:

- During April $300 USD was wired into Mt Gox and $30m USD was wired out.
- 3600 BTC are mined daily

Those facts or fundamentals affect supply/demand. Stories about Coinbase raising $5m etc, probably add to the narrative but let's not confuse that with fundamentals.

[amencon]

Well I never got a reply so let me rephrase: Is there any way to quantify risk over time?

The chance of something drastic happening like GOX getting DDOSed or something of the sort increases over the time doesn't it? Therefore the longer a price has risen or had steady growth doesn't the chance of a crash or downturn increase? Or is that faulty logic?

Good question.  One way to look at it I suppose is one day at a time.  Would you say that on any given day the odds of something drastic happening is the same as any other day?

If so, I'd say thinking the odds of the event increasing would be falling for the gambler's fallacy.

http://en.wikipedia.org/wiki/Gambler's_fallacy