Hedged Approach to Generating Income & Appreciation with Cryptocurrency
By: Jake Ryan
Tags: Blockchain, Investing, Crypto, Bitcoin, Cryptocurrency

For the past few months, I’ve been learning more and more about cryptocurrencies. I’ve been reading blog posts and articles. I have also been listening to podcasts, like Tim Ferriss who interviews legendary investors like Naval Ravikant and cryptocurrency masters like Nick Szabo, as well as Laura Chin on Blockchain and Cryptocurrency and Adventures in Finance — 52 New Kids on the Blockchain. I love walking on the fine sand on the beaches of Santa Monica, listening to all sorts of new ideas in the various podcasts of the week.

So much good thinking is happening out there. One of those good ideas that has really taken off the past year is cryptocurrency. Here is a primer on the topic, along with a strategy on how to generate both appreciation and income from this new asset class.

What is Cryptocurrency?

Cryptocurrency is a digital asset that is enforced by cryptography. It is defined as, “a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.” One of its main advantages is that it does not need a trusted third-party like most traditional financial transactions. It maintains a de-centralized ledger that allows for transactional integrity. The most popular cryptocurrency to date is Bitcoin, which started about 7 years ago. The idea came from a white paper written by pseudonym, Satoshi Nakamoto. No one knows exactly who Satoshi is.

What are the top Cryptocurrencies?

To date, there are over 1600 different cryptocurrencies. There is a top tier of cryptocurrencies, which are Bitcoin and Ethereum. Together they account for over 60% of the cryptocurrency market cap which you can see, here. Bitcoin was the very first cryptocurrency and, therefore, it has the longest history of use. A few years ago, Ethereum was started to solve some of the issues that Bitcoin did not address. Bitcoin has a very minimized feature set and programming language. An owner can send or receive Bitcoin and can set up functions like multi-signature.

Ethereum can do a lot more, too, as it provides for the implementation of “smart contracts.” It has scripting functionality that allows for a full array of logic to be encoded into an Ethereum application or token. It provides a decentralized Turing-complete virtual machine, the Ethereum Virtual Machine (EVM), which can execute scripts using an international network of public nodes (from Wikipedia). This opens the possibility for a wide array of financial applications to be implemented in Ethereum.

photo by Crew on Unsplash

Buying Cryptocurrencies

There are several ways to buy cryptocurrencies. The easiest way is to open a Coinbase account. From there you can link a bank account and then buy one cryptocurrency. Currently, Coinbase offers Bitcoin, Ethereum and Litecoin. Another way is to set up an account on an exchange. A third option is to meet someone in person and exchange cash for Bitcoin. Most cryptocurrencies are bought with Bitcoin, so it can be good to start with buying Bitcoin and then exchange it for other cryptocurrency.

Lending Bitcoin

There’s a new market to generate big streams of passive income. As the asset class matures, there will be various ways to produce appreciation or income. Even derivatives, like options and futures, will be coming to a cryptocurrency market near you in the not too distant future. Now though, you can lend Bitcoin out to currency speculators who want to have a leveraged position in Bitcoin. Speculators borrow Bitcoin and make more money if the currency continues to appreciate. The knife cuts both ways, though. They can lose more if the currency declines.

There is a great article on how to lend Bitcoin with the goal of producing a passive income stream, here. The transaction is completed on the Poloniex exchange, which allows investors to lend or borrow cryptocurrency on margin. As you can see from the article, right now you can make 0.14% interest per day. That doesn’t sound like a lot but it adds up to over 40% APR per year. That’s a nice return!

Here are some of my actual loans that generated income in 2017

Going For Appreciation or Income

As with any asset class, there are methods and strategies used to achieve appreciation or income. If you buy Bitcoin, you are expressing a position that you think it will go up in price relative to the currency you bought it in. You are effectively, “long of Bitcoin and short of the US dollar.”

When you lend Bitcoin, you no longer anticipate appreciation. If Bitcoin goes up, you do not make any money on your lent Bitcoin. That is the risk of lending, but there is a flip side. By lending, you are able to create an income stream. It is basically a fixed-income strategy. It is not direct lending in promissory notes. Instead of buying the notes, you are directly lending the currency. So even today, you can make money by appreciation or income in cryptocurrency.

A Hedged Strategy — Going for Both Appreciation & Income

I recommend a hedged strategy if you want to invest in Bitcoin. First, I recommend buying both Bitcoin and Ethereum. That way, you have diversified across two currencies instead of concentrating a position in one. That diversification will provide a hedge in case one of the currencies goes down.

The second way I would hedge is to have an appreciation and income strategy. I would have, say 50% of my cryptocurrency investment aiming for appreciation by buying and holding the cryptocurrency. I would then have 50% to provide lending. My goal is to create a fixed-income stream that will hedge my appreciation strategy.

Consider this math. Assume we go with the 50/50 strategy. Here are a few options of outcomes —

If BTC goes up 100% in a year, you make 70% — (50%*100%) + (50%*40%). If BTC goes down 50% in a year, you only lose 5% — (50%*-50%) + (50%*40%). If BTC goes up 10% in a year, you make 25% (50%*10%) + (50%*40%)

This hedge position allows you to create a much better probability of making money on your position. The investment calculus will change based on interest rate you can secure (0.14% referenced above), but the idea of a hedged strategy still makes sense.

photo by rawpixel on Unsplash

Putting It All Together

If you are interested in cryptocurrency, start learning more about it. In my opinion, having a more-advanced, hedged strategy will give you a better chance of making a return on your investment. Consider holding some cryptocurrency for appreciation and lending some to generate a passive income stream.

Happy Hunting!