A closer look at asset bubbles
The topic of asset bubbles has come roaring back into the spotlight recently. With the record-breaking rallies seen in stocks such as Tesla and cryptocurrencies such as Bitcoin last year, we are hearing more and more about bubbles in financial markets. Now, while bubbles themselves might be grabbing attention currently, they are far from a modern phenomenon. In fact, bubbles have been occurring since the very creation of financial markets.
Before we dig deeper into this, let's just make sure we are all on the same page. For anyone not familiar with the issue, asset bubbles refer to a situation where a certain asset sees an explosiveincrease in value driven purely by speculative demand and not supported by traditional fundamental analysis. Bubbles can occur in any asset or instrument where there is a market.
Quick History Lesson
The very first speculative bubble occurred in 1630 in the Netherlands and is known among market historians as "Tulip Mania". Without giving you too much of a history lesson, essentially what happened was that the recently introduced tulips at the time became incredibly fashionable and sought after. With increased popularity came increased demand and higher prices consequently. Soon, a futures market developed so that buyers could lock in prices on future deliveries of tulips. However, speculators soon overtook the market with the price of tulips exploding over the course of a few months as traders bought tulips just to sell them on at higher prices. At the peak of the bubble, some tulip contracts were exchanged as many as ten times a day before the market shortly crashed.
How Bubbles Form
So, you might be wondering what tulips have to do with modern markets? This basically gives an example of how all asset bubbles work. A particular asset begins rallying because of good fundamentalsand increasing demand. Speculators sense an opportunity to make money and so start buying in bigger size, more speculators join the market as prices continue to rise exorbitantly until the bubble bursts and price collapses. Typically, this occurs when the euphoria among speculators runs out potentially due to an external factor or simply due to profit taking. As prices start to reverse, more and more traders cut their positions exacerbating the fall.
Some more recent market bubbles:
The dot-com bubble 1995 - 2000
The US housing market bubble 2002 - 2006
The Commodities bubble 2002 - 2008
The Cryptocurrency bubble 2016 - 2018
Characteristics of a Bubble
What are the defining features of a bubble and how to spot them?
The very simplest answer would be that if the chart of any instrument or asset shows price going virtually straight up, over a consistent period of time - chances are it's a bubble.
The chart above shows bitcoin. And you can clearly see the two period which we would define as bubbles. The first is the parabolic move higher into 2018, which then crashed. The second is the parabolic move higher over the last six months - which too is now potentially reversing.
Stages of a Bubble
In terms of the defining characteristics of a bubble, the giveaway signs are usually as follows:
1. A sudden positive shift in market sentiment such as everyone suddenly turning bullish a stock or a commodity.
2. An influx of speculator interest - this is usually the first stage at which the asset starts to properly gain in value.
3. Exponential rise in value - at this point, speculators are driving the rally and it is usually at this point that mainstream media begins reporting on "bubble", luring in lost of smaller speculators and the bubble is nearing its peak.
4. Profit taking - this is when the smart money starts to exit their positions, sensing the danger ahead. A bubble is not driven by fundamentals, merely speculation and so has no longevity, once profit taking kicks in this starts to trigger the end of the bubble
5. Panic and crash - as prices start to reverse, speculators begin to exit their positions in greater numbers, adding fuel to the fire and sending price crashing lower.
How to Trade Bubbles?
So now, you know what bubbles are and what they look like, the big question is, can you trade them?
Bubbles are the perfect example of a double-edged sword. They offer both the allure of potentially large and quick gains but also the risk of swift losses. The big issue with trading bubbles is that you never know at which point of the cycle you are entering. If you enter near the start or the middle of the exponential growth phase, there is a high chance of making a profit. However, if you enter near or at the peak, you can quickly see heavy losses. As such, trading bubbles comes down more to luck than skill.
Risks with Trading Bubbles
The issue is that as price is rising so quickly, typically it will have broken out above any key technical levels so the typical bull trend method of buying as price breaks resistance will no longer be possible. This leaves only buying blindly as price advances. The issue here is that given the volatility, it is very easy to end up getting a bad fill, placing you immediately at a disadvantage. One option is to buy call options above the market price which will be triggered if price trades up through the strike price (entry price). This can work, however, depending on how quickly price is advancing, the option might be quite expensive, again hindering the potential for gain.
Selling as Bubble Bursts
Another option is to wait for the market to begin reversing and sell the reversal. This can work better because there will be some technical levels to play as the market begins to descend for example, selling price as it breaks down through prior lows.
The chart above shows the reversal in Bitcoin following the 2018 bubble, there are plenty of support levels to sell on the way down. Another option is to buy put options as the market begins to reverse. This is where the trader profits if price breaks below a certain price, which will be lower than the current market price.
Obviously, bubbles are certainly an exciting, yet risky feature of financial markets and there will always be traders who chase them and some who win and some who lose, just like every other day in the markets. What is really important to keep in mind is to always manage your exposure to markets no matter the situation.
The article was submitted by Tickmill's Research Team.
Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the authors, and not to the authors' employer, organization, committee or other group or individual or company.
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