What if there were two straight lines between which all of Bitcoin's price action could be contained?
If such lines exist, they could provide tremendous insight into the future price of Bitcoin.
As it turns out, the Bitcoin power law corridor theory hypothesizes that such lines may exist. However, in order to see these lines within a price chart, one must dramatically change one's frame of reference. In this post, I will attempt to change your frame of reference and transform the chart of Bitcoin so that its entire price history is contained between two straight lines.
First, here's a chart that shows the entire price history of INDEX:BTCUSD
Next, I will log scale the chart. Many users on TradingView know how to log scale their charts, but if you do not, .
As shown in the chart below, after I log-scaled the chart, I then adjusted the y-axis such that each value on display is a power of 10.
Now, here's the part where you have to change your frame of reference.
Up until now, you have only seen charts on TradingView with a linear x-axis (time). However, in some cases, it is appropriate to plot time using a logarithmic scale. This is because a logarithmic scale compresses the time dimension, making it easier to see trends over very long periods of time.
Therefore, one can log-scale the time axis of one's charts to observe the movement of Bitcoin's price over long periods of time. When this is done, Bitcoin's price appears to be contained between two straight lines. Bitcoin is bound by these two lines as it oscillates with each halving cycle. As the effects of each halving cycle diminish over time, Bitcoin's price converges towards a singularity.
Why does Bitcoin's price action behave in this manner? The answer is that Bitcoin's price is an oscillatory logistic growth function. Logistic growth functions approach some finite horizontal asymptote over time. However, when both the horizontal (x-axis) and vertical (y-axis) are logarithmically scaled, the logistic function transforms into a straight line. To read more about the significance of Bitcoin as a logistic growth function, including how it informs my cryptocurrency investment strategy, you can check out my post below.
There are some criticisms of the power law corridor theory, including that Bitcoin's price data does not sufficiently meet certain assumptions about regression that must be true in order for the theory to also be true. These criticisms are outlined in this article. Additionally, the theory breaks down in the event that the U.S. dollar enters into hyperinflation. In this event, the price of Bitcoin will begin to move up hyperbolically rather than linearly, even on a logarithmic scale. Some argue that rather than moving within a power law corridor, Bitcoin's price moves according to a hyperbolic growth model. (Watch an animation of this model here). Nonetheless, the power law corridor theory is quite insightful for Bitcoin's current price action.
The chart above shows the extreme magnitude of hyperinflation in Germany's Weimar Republic. For Bitcoin to reach its predicted value under the hyperbolic growth model, the U.S. dollar would need to experience a similar magnitude of hyperinflation during its end stage.
The final thought I want to share may be a bit confusing, but I encourage you to think outside of your usual frame of reference. Here's a question to get you started: Have you ever noticed that when Bitcoin is plotted as a ratio to any other asset, the chart looks exactly like the price of Bitcoin?
The chart above shows (1) the price action of Bitcoin on the left relative to the U.S. dollar, and (2) shows the price action of Bitcoin relative to the price action of the S&P 500 on the right. Despite being used as a ratio to the S&P 500 in one chart but not the other, both charts still look virtually identical.
With the exception of several other cryptocurrencies, no matter what asset you choose, plotting the entire price history of Bitcoin as a ratio to the asset reveals a logistic growth function. This finding is actually quite significant. It implies that Bitcoin is uniquely suited to become the new standard for measuring value. As an asset with increasingly constant scarcity, Bitcoin is able to achieve what no other financial instrument in history has ever been able to achieve: a constant unit by which the value of all other assets can be measured.
You may not realize it, but virtually all of the charts on TradingView are ratio charts. In most cases, the unit of value measurement is the U.S. dollar. However, since the value of the U.S. dollar changes over time, dependent on the supply of dollars set by the Federal Reserve, the dollar's ability to be a constant unit for measuring the value of other assets is thus significantly limited.
The chart above shows the quarterly rate of change of the 2-year Treasury yield. This yield represents the risk-free rate over a two-year period, which reflects the cost of a U.S. dollar over that period. The volatility of the yield in recent quarters highlights the fact that the value of a U.S. dollar has become unstable. This instability underscores the problem inherent in using the U.S. dollar (or any fiat currency) as a measure of value for other assets.
If Bitcoin indeed becomes an asset by which the value of all other assets is compared, then Bitcoin's volatility will go to zero because its value will be measured relative to itself. Bitcoin is only volatile right now because its value is being measured in U.S. dollars. Since the value of the U.S. dollar can change widely over time as the central bank expands and contracts the money supply, this volatility in Bitcoin's price, in large part, actually reflects the volatility in the value of dollars.
In most cases, when an asset becomes the standard for measuring value, is it also considered the risk-free asset. If Bitcoin becomes the risk-free asset, then this fact may upend what Modern Portfolio Theory may consider an optimally efficient, risk-adjusted portfolio. If Bitcoin replaces the risk-free asset, its beta will become equivalent to zero. Suddenly, other cryptocurrencies that outperform Bitcoin, like Ether, may become assets that all efficient risk-adjusted portfolios must contain. This is where my current research ends: The intersection of Bitcoin's mathematical tendency to replace the risk-free asset and how this could drastically impact the findings of Modern Portfolio Theory and the role played by traditional financial instruments.
It is perhaps no wonder then that traditional financial firms are scrambling to create a spot Bitcoin ETF. Bitcoin represents the next step in the evolution of financial markets. Bitcoin has created the first truly trustless monetary system by solving the Byzantine Generals' Problem. This problem of trust has plagued financial markets since the advent of credit, and could only previously be temporarily mitigated by increased money creation. However, this fiat approach always ultimately results in hyperinflation and the collapse of the monetary system.
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Special thank you to @SquishTrade for his editorial assistance. Also, a special tribute to Dr. Harry Markowitz, the father of Modern Portfolio Theory, who sadly passed away as I was researching portfolio theory for this post.
Important Disclaimer Nothing in this post should be considered financial advice. Trading and investing always involve risks and one should carefully review all such risks before making a trade or investment decision. Do not buy or sell any security based on anything in this post. Past results do not guarantee future returns. Cryptocurrencies are highly volatile. Never borrow money or use margin to invest in cryptocurrency. Cryptocurrency is not backed or insured by any authority and is therefore a high-risk asset class. You can lose all or some of your money in cryptocurrency. Please consult with a financial advisor before making any financial decisions. This post is for educational purposes only.
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You can also apply the Bitcoin Power Law Corridor indicator to your chart on TradingView. It's essentially the same as a Bitcoin Log Growth Curve indicator when time is scaled linearly.
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When Bitcoin's market value is plotted against its stock-to-flow on a log-log chart, similar to what we saw above with Bitcoin's price relative to time, it also appears to regress linearly (see image below).
Bitcoin's total market value (market capitalization) vs. its stock-to-flow plotted on a log-log chart. Model created by PlanB.
Stock-to-flow (or S2F) is a measure of the new supply of an asset that is being created over time, relative to the existing supply. A higher stock-to-flow ratio indicates higher scarcity. The model suggests that as scarcity increases, the price of the asset may rise due to the market's perception of its value.
Interestingly, when the market value and stock-to-flow of silver and gold are added to this model, they also appear near Bitcoin's regression line. Further, with the passage of each halving cycle, Bitcoin comes nearer and nearer to silver and gold. This is yet another clue that Bitcoin is showing a mathematical tendency to replace silver and gold.
Physical silver and gold are often considered risk-free assets, or assets with no counterparty risk. This chart therefore presents further evidence that Bitcoin is becoming the new risk-free asset. That is to say, Bitcoin's movement up this regression line toward silver and gold shows its tendency to compete with these riskless assets, and ultimately replace them over time. In the coming digital era, where people and algorithms transact exclusively by digital means, Bitcoin -- with its increasing stock-to-flow ratio -- will likely supplant the role that silver and gold have played in monetary systems for millennia.
In essence, Bitcoin is becoming digital gold.
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The real reason why the SEC doesn't want a Bitcoin spot ETF. No one would invest in the devolving fiat system anymore.
(Below are index/bond ETFs compared against Bitcoin)
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Here's a challenge for you: Figure out how to measure your portfolio's long-term performance using Bitcoin as the unit of value measurement rather than fiat currency.
@SpyMasterTrades, been trying to send you a pm but your setting don't allow. How can i reach out to you brother?
SquishTrade
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Excellent post here SPY! This took a lot of time and effort, and your charts and discussion show it. Overall, it's very informative and educational and may take many readers a couple passes to learn and absorb what you're presenting :)
The argument that BTC’s perceived volatility is actually a reflection of the volatility of the USD is disproven within the article, when you show that BTC price as a ratio measured against almost any other (relatively stable) asset looks just like the BTC/USD chart. This would imply that all other assets are extremely volatile but it is BTC only that is stable. Ratios show the dynamic of Relativity - If I am inside of a fast-moving car and look out the side window, the world appears to be moving quickly while I am not moving at all. If a fast-moving car is traveling in the opposite direction, it will appear to me to be going twice as fast as it actually is. I would counter that it is actually Bitcoin that is volatile. If Bitcoin is your measure by which you value everything else, everything else will appear volatile relative to it. The fact that it has shown logarithmic growth in the past is a function of the law of supply and demand. Because the maximum bitcoin in existence is reaching it’s apex, yet there has been increasing demand has led to it’s exponential growth. However, that is no guarantee it will continue to be in demand in the future. In fact, if it were to be accepted as a reserve currency, it would need to show stability when measured against most other assets, not the volatility it currently displays. You are correct, though in showing that hyperinflation of the USD would cause the price of Bitcoin, as well as all assets to rise exponentially. In such a scenario, I’d want to have something useful, like food or land that can grow food, to be able to trade for the things that I need. Sure, Bitcoin or gold or some other asset that is not under one country’s ability to create as much as they’d like might replace the USD as the reserve currency or medium of exchange in such a scenario, but bitcoin is not the guaranteed winner. Bitcoin sucks as a medium of exchange, it just has the honor of be first and most well-known cryptocurrency. It can continue to experience exponential growth if demand continues to outstrip supply, but bitcoin’s price action is contained in bitcoin itself and does not mean that it is the center of the financial universe.
SpyMasterTrades
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@Somerandodude, Thank you for your well-thought-out comment. I very much appreciated reading it. I agree with much of what you have written.
Here’s my response: You are right that many assets appear volatile relative to Bitcoin. However, this volatility is a derivative of the dollar’s volatility. This is because the pricing of most U.S. traded financial assets (stocks, bonds, etc.) is based on the Capital Asset Pricing Model (CAPM) and Net Present Value (NPV) theory, which relies on the U.S. dollar as the standard for calculating value. So, the price of, for example, Apple’s stock is dependent on the cost of a U.S. dollar. Similarly, the price and yield of Apple’s corporate bonds is based on the price of a dollar (a corporate bond premium is the rate above the risk-free rate and the risk-free rate is merely the cost of U.S. dollars).
Additionally, producers of certain goods price their goods using pricing models that use the dollar as their basis. Producers seek to price their goods such that the pricing achieves a certain degree of stable U.S. dollar value. For example, egg producers price their goods so that they are extremely stable in dollars. Therefore, when we see volatility in the price of eggs when measured in Bitcoin, it’s a derivative of the dollar’s volatility relative to Bitcoin, which in turn is a derivative of the supply fluctuations of the U.S. dollar (set by monetary policy), and not so much a result of supply fluctuations of Bitcoin.
So, yes, Bitcoin appears volatile relative to most assets, but that is merely because, as the world’s primary central bank reserve currency, the U.S. dollar is the underpinning of how most assets are valued. This is true even if an asset is priced in Chinese Yuan (CNY). Since the CNY like many other currencies is, in large part, pegged to the value of the U.S. dollar, then this analysis holds true even when an asset is priced in a different currency. (To be more technical, the CNY is allowed to trade within a range of value to the U.S. dollar, but since this range is quite narrow and is kept strictly intact, it largely functions as a peg).
You are also correct in that demand and supply forces dictate the price of Bitcoin, as they do the price of everything. However, Bitcoin is a unique financial asset in that, over time, supply becomes increasingly constant. In this regard, Bitcoin is uniquely suited to act as a stable measure of value. As for waxing and waning demand, this plagues all assets and is an immutable attribute of the marketplace that causes it to produce efficient pricing. So, yes, Bitcoin is subject to fluctuations in demand, but no asset isn’t (absent government control). Therefore, the key to measuring the stability of an asset as a measure of value is supply. Indeed, once an asset becomes a central bank reserve asset, it is universally demanded and is assigned value by law (legal tender).
SpyMasterTrades
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@Somerandodude Thanks again for your wonderful comment, and I hope to be fortunate enough to receive further comments from you on my future posts!