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Coming Soon: A New Way to Lose Your Shirt Investing in Bitcoin and Ethereum

By Sean Williams – Jul 26, 2017 at 9:21AM

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Derivative contracts for bitcoin and ethereum will soon make their debut.

While few industries have rivaled the growth of marijuana stocks or cloud-computing companies over the past year, no investment has soared higher than cryptocurrencies. In particular, bitcoin has quadrupled in value over the trailing one-year period, while the smaller ethereum has seen its price rally by almost 2,400% just since the year began! At one point in June, ethereum was up more than 5,000% on a year-to-date basis.

Here's what lit a fire under cryptocurrencies in 2017

Why have cryptocurrencies caught fire? The answer probably lies with a confluence of factors.

A physical bitcoin on a red background.

Image source: Getty Images.

To begin with, some pundits view cryptocurrencies as the wave of the future -- a new, more secure, blockchain-based technology that can digitally record and store transactions and, in the case of ethereum, act as a smart contract that allows people to make agreements and oversees enforcement of those agreements in a secure manner. In other words, investors view the technology that underlies cryptocurrencies as potentially scalable for the financial sector, as well as other sectors.

To build upon this point, we've also been seeing a pretty steady uptick in the number of businesses willing to give bitcoin or other cryptocurrencies a shot. Numerous brand-name businesses now accept bitcoin as a form of payment, and the marijuana industry has been tinkering with using bitcoin services as an intermediary between financial institutions and consumers who want to pay with their credit or debit card. We've also seen the rise of the Enterprise Ethereum Alliance, which now features in excess of 150 organizations that are testing ethereum's underlying technology in pilot or small-scale programs. 

Weakness in the U.S. dollar could also be a good reason cryptocurrencies, especially bitcoin, have thrived. President Trump has to be thrilled with a falling U.S. dollar, since it'll make U.S. exports all the more attractive. However, investors are none too thrilled to see their currency being devalued, and are thus looking for alternative places to park some of their wealth. Traditionally, gold served as this safe-haven store of value, since it often moves opposite of the dollar and is a finite resource. Lately, though, some investors have been instead flocking to bitcoin. Bitcoin's protocol calls for no more than 21 million coins, meaning it, too, is perceived to be a finite resource like gold.

A frustrated stock trader grabs his head while looking at his computer screen.

Image source: Getty Images.

Holy risk, Batman!

Despite the success of bitcoin and ethereum, these digital currencies have also been exceptionally, almost nauseatingly, volatile since the year began. Ethereum wound up falling from a high of $407.10 on June 12 to a low of $130.26, on an intraday basis, just five weeks later. That's 68% of its value, or well over $20 billion in market cap, erased in a veritable blink of an eye. Bitcoin has seen volatility of its own, with coins hitting $3,000 briefly on June 12, before falling below $2,000 on July 16. These moves are not for those with a weak stomach.

But if there's one thing the U.S. financial industry knows how to do, it's making a risky asset even riskier.

As announced by the U.S. Commodity Futures Trading Commission in a unanimous vote on Monday, digital currency-trading platform LedgerX has been given the green light to begin listing options for bitcoin. Options grant an investor the right to purchase or sell shares of an asset at a strike price in the future. In effect, the investor is making a bet on the future price movement in a security within a specified time frame.

Said LedgerX CEO Paul Chou, via CNBC: "A U.S. federally regulated venue for derivative contracts settling in digital currencies open the market to a much larger customer base. We are seeing strong demand from institutions that previously could not participate in the bitcoin market due to compliance restrictions against unregulated venues." Chou believes bitcoin options could be launched this fall for institutional investors, with ethereum options to follow a few months later. After that, presumably, retail investors would have a chance to purchase bitcoin and ethereum options.

However, for those unfamiliar with option strategies, especially with exceptionally volatile assets such as cryptocurrencies, options traders could get eaten alive. I can only venture a guess at this point that the time premium, given the inherent volatility in bitcoin and ethereum, is going to be off the scale, making it very difficult to earn a profit utilizing options. And according to data from the Chicago Board Options Exchange, about a third of options contracts already expire worthless. I'd opine this figure could be significantly higher with bitcoin and ethereum options.

An investor holding up his hands as if to say "no thanks."

Image source: Getty Images.

Thanks, but no thanks

While bitcoin may offer appeal as a payment platform of the future, and ethereum's scalability for enterprises could add long-term value, there are so many questions at this point that investors would be best suited sticking to the sidelines.

For starters, we're seeing an influx of inexperienced investors in cryptocurrencies who are pushing the value of these coins higher. Just scroll through your favorite social-media application and count the number of bitcoin and ethereum ads you come across that promise to help you get rich quick. That's usually the sign of a bubble that's readying to pop.

Cryptocurrencies are also hindered by exchange decentralization. On one hand, digital currencies such as bitcoin benefit from having a decentralized network, which protects it from large-scale cyberattacks. On the other hand, decentralized exchanges create undue volatility in the underlying prices of these coins and don't help in any way to legitimize bitcoin or ethereum for businesses and investors.

Bitcoin and ethereum have a long way to go before they prove their worth to this Fool and investors.

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