Bitcoin vs. Bullion: What's a Better Way to Spend $1,200 ...

Posted: 04 Dec 2013 05:30 AM PST

The financial media are trying to figure out whether Bitcoin is another unsustainable asset bubble, or a new kind of gold.

But even though they are trading for roughly the same price, with Bitcoin trading above $1,100 and gold bullion in the $1,200-per-troy-ounce area, a world of differences separate these high-flying forms of money.

Bitcoins are a digital virtual currency (DVC) created by anonymous programmers around 2008-'09. They are 100% digital. There is no physical silver, copper, gold, plastic or even paper behind Bitcoins. They exist entirely in the digital world.

Programmers, engineers or anyone can "mint" Bitcoin by solving mathematical riddles — literally out of thin air. A few newly created "exchanges" are the most organized component of the Bitcoin frenzy. These exchanges are unregulated and require no licensing by any state.

The Bitcoin frenzy has been featured in the mainstream media as a speculative investment opportunity yielding big profits. Because of the media attention, Bitcoin prices have gone parabolic up and down.

I always tell investors that they must understand the valuation of every investment they own or are considering. And when it comes to an "intangible" asset such as a digital currency like Bitcoin, it's even more important to understand just what it is you're buying …

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What's the True Value of Your Investment?

Investors must consider the true value of an investment, which is often different from its market price. That's because the market price will normally gravitate to the true value of an investment.

When you're investing in natural resources and their related stocks, ETFs and currencies, some influential factors include:

Replacement cost
Production cost
Balance of payments
Dividend yield
Discounted cash flow analysis
Book value
Comparison analysis

For example, we know both the market price of gold and the cost to produce an ounce of gold. Every few years we go through the analysis. The input costs include royalties, environmental cleanups, materials, labor and processing. All have been going up.

Currently the total cost to produce gold is about $1,100.

Many variables determine the value of a currency:

The assets (resources that back the currency)
The size of the countries' economy (GDP)
Inflation
Interest rates
Rule of law
Debt
Political system
Accounting systems and reporting
Transparency
The diversity of its industries
The educational attainment of its citizens, etc.

If we used the variables listed above to value a Bitcoin, it would have no intrinsic value.

This is what participants in the Bitcoin market should understand. The downside risk of Bitcoin is 100%. You are risking a complete and total loss of any money invested or used speculating in this "virtual digital currency"!

So … how does one go about inventing this kind of "invisible money" … and, more importantly, making it sustainable?

Bitcoin's Beginnings

The creators of Bitcoin are obviously computer geniuses, but they don't know about economics. Their concept shows no awareness of how to build a financial system that economies, companies, merchants and consumers will use with confidence and trust.

Perhaps this was not their intent. There's a lot we don't know about Bitcoins and the people behind it.

Confidence is very important in an investment. To build confidence requires trust in the people who stand behind it. Some good questions to ask are…

Who started Bitcoin? Where do they live?

Where were they educated? What degrees do they have?

Who is in charge now? How much are the paid?

Are they trustworthy? Do they have criminal backgrounds?

Here's another question …

Are Bitcoins Even Legal?

No countries have deemed Bitcoins legal. In the U.S., Bitcoins are not legal tender.

However, government regulators have left the currency alone — for now. As you will see in the chart below, Bitcoin prices spiked during a congressional hearing regarding DVCs.

Some analysts believe criminals are using Bitcoin to hide and launder their illegal activities. As I said above, consumers, investors and speculators are not protected against theft, fraud and losses in Bitcoin transactions.

Regulators have mandated that Bitcoin exchanges report large or suspicious activities to the Treasury. Bitcoin made the news earlier this year because one of the Bitcoin exchanges did not follow this mandate.

The Bitcoin Frenzy Will Bring Competition

Bitcoin has plenty of competition, choices if an investor wants to have exposure to currencies. DVCs have relatively low barriers to entry.

A recent WSJ article listed the most popular DVCs, including Bitcoin, Litecoin, Peercoin, Namecoin and Bbqcoin.

Yes, Bbqcoin … and it's worth about 0.00000474 Bitcoins.

As DVCs get more attention, you will probably see more competition.

Participants

Every investor must understand the universe of participants in a market.

It's hard to determine who the dominant participants in the Bitcoin frenzy are, but they probably include technology workers, currency traders, hedgers, criminals, speculators and novices.

Some of the smartest traders we know have also taken a position.

I doubt traditional stock, bond or commodity investors and large institutions are involved, however, because of their focus on valuations.

Bitcoin at $1,150: Time to Talk About a Bubble?

Throughout history, the promises of fast profits have led to some incredible speculative bubbles. One of the most famous was the Dutch "Tulip Mania."

At its peak in February 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman.

The classic book on bubbles is Manias, Panics and Crashes, by Charles P. Kindleberger and Robert Aliber. According to their book, a bubble involves an unsustainable (parabolic) move in prices or cash flows.

The book lists 10 of the most famous and biggest bubbles in economic history:

The Dutch Tulip Bulb Bubble
The South Sea Bubble, 1720
The Mississippi Bubble, 1720
The U.S. stock market bubble, 1927-'29
The surge in bank loans to Mexico and other emerging countries in the 1970s
The Japanese real estate and stock market bubble, 1985-'89
Scandinavian's real estate and stock market bubble, 1985-'89
Thailand, Malaysia, Indonesia and other Asian countries real estate and stock market bubble, 1992-1997
Surge in foreign investment in Mexico, 1990-'93
U.S. technology stock bubble, 1995-'00

You can add another to the list: the U.S. real estate and subprime mortgage bubble, 2003-'08.

Bitcoin looks a lot like these historic bubbles, especially with this key characteristic …

Shaky Ground and Huge Swings Up and Down — Have Already Occurred!

The Bitcoin frenzy has already experienced several setbacks that hurt its credibility …

A programming vulnerability allowed over 184 billion Bitcoins to be generated.
A new version of Bitcoin caused confusion and erroneous account balances.
Processing delays.

One of the possible creators of Bitcoin (one of the individuals who own the encryption patents to Bitcoin) communicated that he "had moved on to other things."

There are sure to be more mishaps. Investors must always avoid emotional decisions based on fear and greed. Fear is the most harmful decision and emotion.

Mt. Gox is the main website where participants can trade Bitcoin. Here is a chart for the Bitcoin for one year, 2011.

Pretty flat, eh?

The Bitcoin price hardly moved the first four months of this graph.

In June 2011, Wikileaks began accepting Bitcoins as donations, giving Bitcoins some legitimacy. The news wore off and prices crashed in late 2011.

Here is chart of a parabolic move early this year:

Again, parabolic moves like this are a sign of speculation, illiquid markets and bubbles. It would not take a lot of money to move prices up and down.

Traders and investors must understand the nature of volatility of fear and greed. Let's look at an example:

The above chart is of a parabolic move earlier this year for Bitcoin. Notice that it took several weeks to go from $50 to $250 (greed). It only took a few days to crash from $250 to $50 (fear).

The left side of the graph shows volume for the Bitcoin. The blue trendline is volume with the size of volume on the left side of the chart. Volume spiked to 30K when prices collapsed.

There are several points here: Bitcoin has little volume and is illiquid. You see more volume on selling vs. buying because fear is a powerful emotion.

Below is the most recent parabolic move:

Last month a U.S. Senate committee had a hearing on DVCs. Federal agencies told lawmakers that currencies such as Bitcoins can be can be "legal means of exchange." The news caused the Bitcoin to go parabolic.

How much do you want to bet that this latest move will wind up like the move earlier this year? You see that volume is much stronger on the selling than the buying.

The important lesson here: FEAR is more powerful than greed. Money can disappear very quickly.

I heard an old investment adage early in my career. I still believe it:

WHEN IN DOUBT — STAY OUT

Take your cue from the action of the Bitcoin pioneer who "moved on to other things."

Gold has proven itself for thousands of years to hold its value. I do not recommend selling it in order to buy Bitcoin, an asset whose intrinsic value is probably zero.

The price to produce gold is about $1,100 per ounce currently — the price of one Bitcoin.

Gold will probably go higher as demand from investors and global central banks grows, supplies become more expensive to find and develop, and production costs increases.

Sincerely,

Dan Hassey

P.S. Why does the world's richest and most-powerful man need $250 oil? To ensure his country's profitability … and his own. You can discover oil riches of your own right alongside him. Here's how.

Dan Hassey is the Senior Stock Analyst for James DiGeorgia's Gold and Energy Investor newsletter and his Superstock Investor service.

Using Options to Capitalize on Strong Fundamentals for Gold ...

Posted: 04 Dec 2013 02:13 PM PST

December 4, 2013

My trading partner JW and I had a great talk the other day which spurred to the creation of this interesting and educational gold futures trading article we wanted to share with you.

Throughout most of 2013, gold futures have been under major selling pressure. Gold opened the year trading around $1,675 per ounce. As of the 12/02/13 close, gold futures were trading around $1,220 per ounce which would mean that thus far in 2013, gold futures have lost more than 27% of their value.

Looking back to September of 2011, gold's all time high came in around $1,923 per ounce. In a little more than 2 years, gold prices have dropped around $700 per ounce representing a total loss of more than 36% based on the 12/02/13 closing price. I would say most analysts would agree that gold has been in a bear market over the past two years.

Before we begin looking at a few ways to use the gold etf GLD option structures to take advantage of higher future prices in the yellow metal, I thought I would focus readers' attention on some bullish fundamental data for gold. Let us begin with a chart of the Federal Reserve's Total Assets which is shown below.

The data shown above comes directly from the Federal Reserve's public database itself. Essentially, this is the Fed's balance sheet and its obvious that the money printing has gone parabolic. The Federal Reserve prints money to purchase Treasuries and mortgage backed securities which end up on the Federal Reserve's balance sheet.

Interestingly enough, the chart above illustrates the amount of money the Federal Reserve has been printing since the beginning of 2011. The chart below illustrates the price of gold futures during the same period.

Gold futures have moved lower in price while the Federal Reserve has printed an unprecedented amount of money through the quantitative easing program. It has been pointed out that the flow of liquidity is more important than the total money stock, but these two charts when viewed together are rather odd at the very least. However, we must all continue to remind ourselves that there is no manipulation of any kind going on . . .

Another odd situation has developed regarding the gold miners and the price of gold relative to production costs. The gold spot price has essentially moved down below the average 2013 cash cost of $1,250 – $1,300 per ounce. Price action in gold futures is rapidly approaching the marginal cost to produce gold which is around $1,125. The chart of the various gold production costs is shown below.

Chart Courtesy of zerohedge.com

Gold prices closed on 12/02/2013 at $1,218 per ounce. Based on the closing price, gold futures are less than $100 per ounce away from the marginal cost to produce gold. If the yellow metal's price moves below the cash and marginal cost of production gold mining volumes world wide will begin to decline.

The gold miners have likely already started lowering their production levels at current prices. The production slow down would only accelerate should prices move down below the marginal cost of production. I believe that these production costs will help put a floor underneath gold prices in the longer-term.

It is widely known that there is strong current demand for physical gold coming from Russia, India, and China. If the gold miners began to slow production levels considerably it is likely that physical gold prices could explode to the upside.

Should production levels decline while demand remains at the same level all of the manipulation in the world could not stop gold prices from arriving at their natural market based price. I think most readers and analysts would agree that the natural market based price is higher, not lower from the marginal and cash costs of production.

As many readers know, my primary focus as a trader is in the world of options where I focus primarily on implied volatility and probabilities to formulate new positions. Unfortunately options on gold futures are fairly limited and are not actively traded. However, the options on the gold ETF GLD are very liquid.

With the longer term fundamentals intact, I thought I would post a few possible trading ideas using GLD options to get long GLD while giving the trader some duration to allow for the time needed for the trade to work.

A fairly cheap way to construct a longer-term bullish position in GLD would be to look at a June 2014 Call Debit Spread or a June 2014 Broken-Wing Call Butterfly Spread.

These trade structures use multi-legged constructions and would essentially allow traders to get long GLD.

Due to the inherent leverage built into options, these positions would not require near as much capital as buying an equity stake in GLD or being long gold futures. The trade structures mentioned above would also mitigate Theta risk, also known as time decay so the passage of time would not have a significant impact on the trade's overall profitability.

In fact, both of these trade structures would actually benefit from the passage of time in terms of profitability down the road. There are a variety of other trade structures that could be used to benefit from higher prices in GLD while simultaneously capitalizing on the passage of time as a profitability engine. Each trade construction carries a variety of different potential risks as well as required capital outlay or margin encumbrance.

I want to be clear in stating that these trade structures are purely for educational purposes and should not be considered a solicitation or investment advice. Whether we are discussing gold futures, GLD, or GLD options these are all paper investments and they should not be viewed as a substitute for physical gold holdings. Physical gold would likely benefit the most from any supply shock in the future.

In closing, I believe that the fundamental picture for gold is improving by the day. While more downside is likely in the near-term, the longer-term picture for higher gold prices in 2014 and beyond seems quite likely.

In a world where central banks are printing fiat currency at record rates, at some point in the future physical gold prices will no longer be able to be held back from true price discovery.