In my previous market wrap, I posted a chart similar to the one below highlighting the current action in Bitcoin. Given that I find compression patterns with declining volatility interesting it’s worth spending a little bit more time analysing what exactly is happening with price at present.
However all these things have to be viewed in context. As we can see from the chart below Bitcoin is in the middle of a horrendous drawdown. This drawdown has undoubtedly shattered many accounts. However the same rules apply to Bitcoin as every other instrument, if you do not have some form of risk management protocol in place then you are really just hoping that things will go your way. It also pays not to be a purveyor of videos put out by 20 year olds who still live at home with their mother who had the habit of proclaiming that Bitcoin was going to $1,000,000.
When looking at a chart with drawdown on it one of the things we have to be careful of is the temptation to assume that all instruments recover from all drawdowns. This is particularly true when looking at an instrument that is surrounded by a great deal of hype and wishful thinking. But we have to be fully aware of the fact that the price of Bitcoin could over the course of time full back to $10,000. Drawdown charts are in no way predictive of how far the instrument will fall. An instrument can only stop falling when its price goes to zero. It’s important to remember this so that any form of analysis we perform is not in any way coloured by our desire for what an instrument should do. One of the greatest failings traders have he said they don’t actually trade the market they trade their feelings and by definition, they’re trading what they want to happen rather than what is actually happening.
When we look closer at the original chart there are a few things that pop out and I mentioned these in the market wrap but they are worth mentioning again as general points of market tradecraft. When I look at this chart the most immediate thing, I see is not necessarily the compression pattern that is forming which I’ve highlighted on the price chart but rather the drop in volatility that is occurring. I find this drop in volatility interesting, particularly in an instrument that has been relatively quite volatile and subject to some extreme mood swings. What this compression in volatility tells me is that there is a degree of uncertainty in the minds of traders and this uncertainty is being manifested in smaller and smaller trading ranges hence the compression in volatility.
Traditionally this sort of pattern irrespective of the instrument it occurs in is a harbinger of a breakout and it is here that I have to issue another one of my warnings. When traders see charts like this the automatic tendency is to draw the chart and then draw a line on where you want the price to go so this sort of chart would instantly be followed by an upward sloping arrow. Social media is full of these forms of implied predictions. This sort of pattern is an even money bet it is not a guarantee that when the compression comes to an end the price will break up. There are no guarantees in markets at all.
This raises the question of what should our action be in light of this analysis. The answer to that in the short term is quite easy there is no action to be taken. This is a simply wait and see situation it is one of those situations that test a trader’s patience and in many ways acts as a firebreak on one side of the breaker those traders who can wait for confirmation on the other side are those who go early and end up getting burnt. the secondary issue with these sorts of patterns is that they do have an effect on our money management and they had this effect in two ways. initially, when the breakout occurs we have a rigid point to which we can anchor our initial stop. Allied to this is the very low volatility which if you are using a volatility based position sizing mechanism means that your position size will be commensurately larger than it might ordinarily have been.