Not a day goes by without some news on big unexpected price changes of Bitcoin and other cryptocurrencies coming out. Truly no other asset receives such controversial attention from the media and had so much speculation about its price movements, to a large extent because of how innovative, underresearched and unique it is. Many academics and traders have attempted to model its price movements by employing various tools of technical analysis and econometric modelling. Recently, some traders started to employ the stock-to-flow (S2F) model to price Bitcoin and other cryptocurrencies too. Let’s have a look at what this model is, how it can be used to price assets with limited supply and what is means to your trading process on eToro.
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What is stock-to-flow ratio?
Strictly speaking, stock-to-flow model is not an innovation and has been used to model prices of scarce assets with limited available supply such as precious metals like gold and silver for a while now. It is based on the idea that scarcity of an asset leads to it having a greater value. However, the first time it was used for Bitcoin was only in the beginning 2019; because the supply of this asset on the market is fixed by the way it was engineered, it is now being compared to other scarce assets like metals and commodities by some investors. A general formula for the stock-to-flow ratio is units of stock divided by units of flow, so the quantity of asset that is kept in reserves by the quantity that is produced every year.
How does it work?
For the simplicity of this example, let’s assume a type of a rare metal was recently discovered. Because of its scaricity, it is kept for investment purposes and currently there are 100 000 units of it available in reserves and these units are referred to as the ‘stock’. Every year there are additional 1000 units mined, which are referred to as ‘flow’. We can then obtain the stock-to-flow ratio by dividing the total number of units in stock by the number of flow units, 100 000 / 1000 units = 100. Is this value too high or too low? As always for financial metrics, this ratio is relative and depends on what you are comparing it to. Assets with higher stock to flow ratio are more valuable to investors as they indicate greater scarcity since less and less additional supply is added in relative to the existing amount of that asset. This ratio is mostly relevant to assets with limited supply, such as precious metals like gold and silver and recently cryptocurrencies. Therefore consumption goods and commodities produced industrially would have a relatively low stock-to-flow ratio; this makes sense as these assets are consumed, production and inventories of them are kept to satisfy the contemporary market demand, not for investment purposes.
Stock-to-flow is very important to scarce or rare assets because their valuation depends on how much new supply can be generated in comparison to their total existing supply. We can then say that price appreciation is based on assets’s rarity. However, it is not scarcity only that creates value; in fact there is quite a big quantity of precious metals like gold in global reserves. What matters here is the fact that the yearly production of these assets as compared to existing amount in stock is quite small and the rate of extraction doesn’t really change over time.
Stock-to-flow and cryptocurrencies
Why is this measure actually needed? It basically became a very important metric in technical analysis for price predictions in scare assets and now also cryptocurrencies such as Bitcoin. This model basically compares Bitcoin and cryptocurrencies to scarce assets like gold, silver, platinum in order to price them. Despite being a digital asset, the quantity of Bitcoin is limited to 21 million coins because of the way it has been set up using mathematical limitations. In fact, around 89% of it has already been mined. This percentage changes approximately every 10 minutes as new coins are mined. Furthermore, some coins are ‘lost’ because its owner has lost their access key to it. Because of this, Bitcoin is actually a scarce asset and it is possible to model its price changes using the stock-to-flow model. It has limited supply, it is expensive to produce new coins and there is a limit to the maximum number of coins that can ever be produced which makes its production quite easy to predict by this model.
The ‘flow’ component of Bitcoin can actually change every time it is halved, which happens every 4 years approximately and involves reducing (halving) the number of coins given as a reward for mining them i.e. adding new transactions to the blockchain. That changes the ‘flow’ of Bitcoin that is available in the world and ensures that the market is not flooded with coins, rising the price of this asset and making it more valuable.
Using stock-to-flow on eToro
So what does the model suggest then? Since Bitcoin and other cryptoassets are scarce digital instruments, their price should increase over long-term according to the model. You can visualize this on a graph that plots Bitcoin’s stock-to-flow ratio over time, suggesting certain price levels by projecting the line in the future and taking into account the expected times of halving.
Some traders may choose to use this model as one of the ways to anticipate price changes in their investing process.
A note of caution
One thing to realize here is that the set up for price prediction using stock-to-flow is just a model and is based on a great number of assumptions. There are many ways to model prices of assets, some more common amongst traders and other, more controversial, to a smaller extent. Many analysts and traders have critisized the model due to its simplicity and the fact that it ignores many other factors that influence an asset’s price. In fact, can we actually compare cryptoassets to things like gold and can we actually base price predictions only on scarcity? Many would answer ‘no’ to these questions. Another question that still remains as a topic for discussion amongst investors is what will happen when all of the Bitcoin will be mined? This model can hardly answer that.
Furthermore, there are many short-term factors that affects the price of Bitcoin making it deviate from the S2F line, including important news, investor behavior, new regulations etc. Remember that cryptocurrencies are extremely volatile, just look at how much the price changed over the last 12 months and how wide its daily range is!
Now, please note that this is just one of models out there used for price prediction. In fact, it is based on many assumption that some believe to be invalid. The outlook of this model is also quite long-term and it is not the model to predict short-term price movements so should not be taken as investment advice. Traders who do not believe in it or prefer to make profits on short-term price fluctuations prefer to use technical analysis to do so. Luckily, there’s plenty of such helpful tools available on eToro.
By now you hopefully have a better understanding of what stock-to-flow ratio is and how it can be used to price scarce assets. Remember that trading both commodities and cryptoassets on eToro involves a lot of risk and should be done with great caution. Best of luck and enjoy using the platform!
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