Crypto Is Cracking: Here Is A Way To Trade It

Crypto cracks over the weekend offer a pairs trade idea

This weekend the crypto market experienced what many in the media ara calling Black Sunday as a variety of  instruments including Bitcoin and Ethereum dropped nearly 20% before recovering somewhat.

At the start of week’s trade the price action in crypto has stabilized but the rebounds have been less that impressive with Bitcoin only up about 1.5% on the day still trading 10% of it’s all time highs. This wild price action in crypto is typical as the asset has the highest volatility of any major investment instrument in the world and the action this weekend may have simply been a quick profit taking move after a relentless rally, but if this is indeed the start of a deeper correction in the whole sector then there could be several ways to play the move without the need to guess the top.

Long BTC/USD vs. COIN stock

One way to mitigate some of the volatility risk  is to construct a pairs trade that would go long BTC/USD and short Coinbase (NASDAQ:COIN) stock. At current prices the pairs trade would require a 20:1 ratio of one Bitcoin unit to 20 units of COIN in order to establish an equal position on both sides. 

Last week the biggest crypto exchange Coinbase went public at a whopping valuation of $84 Billion and actually rose in value to $100 Billion. There are many reasons to believe that COIN stock is grossly overvalued but the underlying thesis for the pairs trade is that the price of COIN stock will be highly correlated to the price action of Bitcoin and will collapse if Bitcoin tumbles as well. 

COIN stock grossly overvalued

Coinbase is the largest crypto exchange in the world and as such enjoys rentier profits from both its size and its dominance of what is essentially a highly inefficient market. To get an idea of the massive transaction fees that Coinbase collects one needs to understand that an average $1000 transaction in Bitcoin on the Coinbase exchange would cost an investor about $40 in commissions not including the bid ask fees. In comparison a similar stock transaction would be essentially free to the investors excluding bid ask fees  and a similar transaction in forex would cost a dime excluding bid ask fees.

The massive profit margins that exist in crypto dealing are due to the fragmentation and the volatility of the market and while most retail investors are unaware or simply don’t care about the fees given massive rally in the sector they will become far more price sensitive as the market matures. The inexorable trend in financial services is towards lower and lower transaction costs and Coinbase which faces stiff competition from a slew of competitors is sure to feel margin pressure as the year proceeds.

Insiders sell most of their allowed holdings

Little wonder then the insiders dumped as much of their stock as possible on the IPO liquidating nearly $5 Billion of their holdings. The firm’s main venture capital fund Union Square Partners sold $1.2 Billion, Coinbase founder Brian Armstrong sold nearly one half of his stock holdings and CFO Alesia Haas sold all her allowed stock on the IPO. Defenders of the stock have pointed out that the reports of wholesale dumping of positions were misleading given the fact that executive management have millions of stock options available to them, but that would only further the point of dilution for public shareholders that would enjoy none of the capital raise were those options to be exercised.

The pairs trade provides a hedged bet on correction in sector

Can Coinbase run higher in the upcoming months despite its gross overvaluation? Yes. But its almost impossible to imagine a jump in COIN stock without a contemporaneous rally in Bitcoin which is why the pairs trade should serve a hedge in the trade. On the other hand if Bitcoin corrects the decline in COIN is likely to be far steeper given its overvaluation and vulnerability to  erosion of margins from increased competition in the space.