A walkthrough for novices on how to use the stock-to-flow model with Bitcoin
The flow of Bitcoin stock
It can be a challenging endeavour to begin investing in cryptocurrencies due to the notoriously unstable nature of digital currencies, which makes it difficult for new investors to make well-informed investment decisions.
In light of these challenges, one might find it useful to make a more structured decision by employing the “stock-to-flow” (SF or S2F) model.
Traditional stock market investments, such as those made in cryptocurrency, rely on investors making educated guesses about the direction in which the value of various assets will move. One model that can assist in this endeavour is the stock-to-flow ratio, and it is one of these types of models.
It is a number that indicates the number of years that will pass before the current stock (supply) can be reached at the production rate that is currently being used. Generally speaking, the higher the number, the higher the price!
The SF ratio has an established track record of correlating with the price of Bitcoin (BTC), which has contributed to its widespread adoption as a method for predicting future BTC price valuations. Bitcoin was the first and is still the most well-known of the world’s scarce digital objects.
In the same way that silver and gold are scarce, their supply is as well; there will never be more than 21 million coins in circulation.
The stock-to-flow concept makes use of the fact that the scarcity of Bitcoin contributes to the currency’s increased value. The stock-to-flow ratio is a method for forecasting the value of Bitcoin that takes into account its digital scarcity.
Is the stock-to-flow model of Bitcoin accurate for predicting its price? This article will take a more in-depth look at the stock-to-flow concept, how it operates, as well as how the stock-to-flow model can be used to invest in cryptocurrency.
The limited supply of bitcoin and its stock-to-flow ratio
According to Nick Szabo, an American cryptographer and computer scientist, scarcity generates “unforgeable costliness” and assigns intrinsic value to an asset. Scarcity also increases the value of an asset.
The technology that underpins Bitcoin ensures that the number of newly minted coins will gradually decrease over time, thereby increasing the currency’s value as a scarce resource. The miner who successfully calculates the hash that is required to validate a block of transactions and produces a proof-of-work is awarded a “block reward.”
The term “Bitcoin halving” refers to the process by which the reward for each block is cut in half every 210,000 blocks. The block reward has been steadily decreasing since 2009 when it stood at 50 BTC. It dropped to 25 BTC in 2012, 12.5 BTC in 2016, and 6.25 BTC in 2020. In the spring of 2024, there will be another halving of the population size.
In the past, the Bitcoin halving has been responsible for driving the price of BTC through the roof. Investors are able to use measures of scarcity to determine the optimal time to invest in Bitcoin (BTC) given that the price of Bitcoin increases when there is less cryptocurrency available for purchase.
The stock-to-flow model makes less complicated predictions about how values will shift over time. It does this by contrasting the current stock of an asset with the rate of new products, which is the amount that is produced each year.
Having a higher ratio indicates that there is a greater scarcity, which typically results in a higher price. A Dutch former institutional investor with the alias “PlanB” is credited with popularizing the concept of the stock-to-flow ratio for bitcoin.
The stock-to-flow method was initially utilized in the context of gold and silver; however, in recent years, the cryptocurrency community has begun to implement the method, most notably in relation to BTC.
Since Bitcoin, just like these other commodities, has a limited supply and a high production cost, the factors of supply and flow are likely to be the most important considerations in determining its value.
Gold production has increased as a direct result of technological developments in the precious metal mining industry. On the other hand, Bitcoin production has become more evenly distributed as a direct result of halving events.
Additionally, in contrast to gold and silver, cryptocurrencies cannot be transformed into physical goods or components of any kind.
Because investors are free to sell any or all of their crypto tokens at any time, this means that each and every crypto token represents a potential supply. As a result, a high stock-to-flow ratio in cryptocurrency indicates relative value rather than absolute value.
This relatively regular inflow makes it considerably easier to anticipate Bitcoin’s stock-to-flow ratio, despite the fact that it isn’t always ideal. As Bitcoin matures as an asset, macro factors will increasingly influence its price.
The ratio of a commodity’s existing stock (the total amount that is available) to the flow of its new product is referred to as the stock-to-flow ratio (amount mined during a specific year).
First, let’s get a grasp on the Bitcoin stock-to-flow formula and how it operates. At the time that this article was written, the stock of Bitcoin was 18,847,331 BTC, which represents 89.74% of the total supply. Additionally, the annual flow of Bitcoin was 328,500 BTC.
The value of the number that represents the stock is subject to fluctuation approximately every ten minutes due to the mining of additional blocks.
When these figures are entered into the stock/flow formula, the resulting SF ratio is calculated to be 57,374 (18,847,331/328,500). As a result, the mining of the current total supply of Bitcoin would take approximately 57 years (without taking the maximum supply and halvings into account).
In addition, the occurrence of Bitcoin halving events raises the S2F ratio by increasing scarcity, which in turn causes the price of Bitcoin to rise.
To understand why Bitcoin is considered a currency rather than a commodity, the most important metric for investors to consider is why Bitcoin is classified as a currency.
Is the stock-to-flow model of Bitcoin accurate for predicting its price?
The Bitcoin stock-to-flow ratio has shown some historical association with BTC price, but the methodology has significant limitations when it comes to forecasting the future value fluctuations of digital assets. This is because the ratio measures the amount of Bitcoin that has been mined rather than the amount of Bitcoin that has been spent.
For instance, the model takes into account only Bitcoin’s supply and pays no attention to the demand for the cryptocurrency.
Supply and demand are the two factors that have the greatest impact on the final price of an asset.
Even though Bitcoin’s supply-to-fee ratio will increase every four years during events known as “halving,” the cryptocurrency’s price will plummet dramatically if demand decreases significantly.
In addition, the Bitcoin stock-to-flow model does not take into account the following elements that have the potential to influence the price of the asset:
1. Volatility.
Despite the fact that Bitcoin’s volatility has significantly decreased over the course of the years, the price of Bitcoin is still susceptible to significant swings.
During a highly volatile period, investors may sell their holdings in a panic after experiencing a significant loss in value. This results in traders liquidating their long positions, which leads to a significant drop in the price of bitcoin.
2. Black swan events.
In the field of economics, “black swan” events are unexpected occurrences that result in significant repercussions, in particular for the price of an asset.
A major regulatory crackdown that effectively prohibits anyone from buying and trading cryptocurrency would be an example of a “black swan” event for Bitcoin because of its potential impact. As a result of such a hypothetical scenario, the price of BTC might experience a precipitous drop.
Supplementary cryptocurrency market projection models
It is common practice to refer to the psychology of market investors as “collective psychology” or “crowd psychology,” and the Elliott Wave Theory applies this concept to the evaluation of cycles in financial markets.
Ralph Nelson Elliott, an American accountant, came up with the idea for the Elliott Wave Theory back in the 1930s.
In accordance with the Elliott Wave Theory, wave patterns can develop in the form of straight lines or with ups and downs in between.
The price fluctuates between impulsive and alternative stages, and these stages repeat themselves in the same cycles across all of the financial markets, including trading in cryptocurrencies.
The waves that can be seen are repeating themselves and are organized into five distinct wave sets. This wave sets a switch back and forth between motive and corrective waves.
The Bitcoin Rainbow Chart is yet another form of the price forecasting model. It is a logarithmic chart that is colour-banded and displays Bitcoin’s price evolution.
Über Holger, the CEO of Holger, used a logarithmic regression that was provided by a member of Bitcointalk going by the name “Trolololo” in the year 2014 to develop the coloured bars.
Holger has admitted that these bands are completely arbitrary and lack any sort of scientific foundation; as a result, they are only accurate until some unspecified point in the future, despite the fact that the hypothesis does not include any timescales.
Users are able to track changes in price over time, ignoring the inevitable fluctuations caused by daily volatility, and obtain a sense of when the best periods were in the past to buy or sell Bitcoin.
According to Holger, the Rainbow Chart does not offer investment advice because it is not possible to reliably extrapolate from historical performance to predict future performance.
However, it does so by dividing the price of Bitcoin into eight bands of an arbitrary colour. These bands are as follows: definite bubble, FOMO (fear of missing out), sell, bubble formation, still cheap, HODL, buy, accumulate, and deeply discounted.
How to invest in cryptocurrencies using the stock-to-flow model
In spite of these flaws, it may be beneficial to understand how to utilize the stock-to-flow model when engaging in cryptocurrency trades.
According to the model’s previous applications, there is a correlation between an increase in the stock-to-flow ratio of a cryptocurrency and an increase in its value. This connection can assist one in making decisions regarding financial investments.
A high stock-to-flow ratio, such as 50 or higher, indicates that relative scarcity is intense, which implies that values will also increase.
After seeing that ratio, an investor might decide to liquidate some of their cryptocurrency holdings in order to capitalize on the asset’s current high price. On the other hand, when the ratio is low but it is anticipated that it will rise in the future, they might buy more.
Understanding how to apply the stock-to-flow ratio in crypto can be a useful financial strategy, despite the fact that it has some inherent limitations. This model should be added to the collection of forecasting tools that one uses when investigating the possibility of investing in cryptocurrencies.
