Why Bitcoin Keeps Falling: The Downward Spiral of the Gamma Trap

Over the weekend, Bitcoin broke through the 80,000 dollar mark and has since been whipsawing, currently trading in the high 70,000s. In just four months, it has fallen nearly 38% from its all-time high of 126,000 dollars on October 6 last year.

Bitcoin and Ethereum are commonly referred to as the blue chips of crypto. When you see a sharp, symbolic coin like this plunge in a short span of time, financial influencers often say things like "to find the bottom, you need to watch the whales’ wallets". That line leans on the fact that all transaction records are left on the blockchain, but in practical terms it is wrong.

The vast majority of coin trading takes place on centralized exchanges. Because of that, exchanges don’t need to send tokens to other wallets: when a trade occurs, they simply record a plus quantity in the buyer’s account and a minus quantity in the seller’s account in their internal database, just like a ledger. The “whale wallet movements” that crypto influencers point to are usually the movements of entities like exchanges that custody other people’s tokens. They compress countless trades that took place inside the exchange into just a handful of on-chain transactions, which makes them unsuitable as a tool for gauging what big players are really thinking. It’s a classic case of the story being better than the reality.

Bitcoin is extremely hard to value. Structurally, it is difficult for it to function as a medium of exchange in the way money does, and in the end, its value is determined by how many people believe in Bitcoin. It is similar to gold, but gold is a mineral that can be physically used once processed, and it has served as a store of value for thousands of years in human history. By contrast, Bitcoin’s 15-year history is hardly enough time to fully test that belief. Up to now, Bitcoin’s price has been linked to the passionate evangelism of a handful of early adopters and the number of converts they persuaded, and those believers have been rewarded with enormous gains. Ultimately, Bitcoin is an asset with a unique characteristic: its value is not determined by information or utility; rather, price itself becomes value.

As with every other financialized asset class, there is a vast array of derivatives built on Bitcoin, and market participants do everything they can to maximize their own profits. Markets can throw up all kinds of scenarios, but in an environment like today’s, where prices are falling, investors who have put large sums into Bitcoin will buy put options to minimize their losses.

If there are buyers of put options, there must be sellers on the other side. These are mainly liquidity providers known as market makers. They are not gamblers betting on Bitcoin’s value. They are mechanical actors that rely on math and algorithms, focused solely on collecting fees and spreads while keeping their risk neutral.

This is where the real culprit behind Bitcoin crashes—a negative gamma feedback loop, or gamma trap—kicks in. When terrified investors rush to buy puts, the market makers on the other side end up holding a large short position in put options. In technical terms, they are in a short gamma position. This is dangerous because the actions market makers must take to neutralize their risk boil down to one rule: sell when the market falls, and buy when the market rises.

When Bitcoin’s price drops, the market makers’ algorithms react instantly. To keep their short put positions hedged, they instruct the sale of Bitcoin in the spot or futures market. This mechanical selling dumps supply into a market with few buyers, pushing prices down further. As the price falls more, the algorithms recalculate that their position risk has increased and that they need to sell even more.

When volatility spikes, things get even worse. The higher the volatility, the more aggressively market makers have to sell, and the volume they unload grows exponentially. By this point, there are almost no human traders left trying to buy the dip. Their place has been taken by ultra-short-term trading algorithms which, the moment they detect a barrage of sell orders, pull their bids and step back from the market.

In the end, there is no one left willing to buy, yet a mechanically mandated wave of sell orders keeps flooding in, creating a kind of vacuum. This is what lies behind a flash crash, where prices collapse in an instant. In the stock market, there is at least a floor in the form of corporate earnings, and at that point value investors step in to break this vicious cycle. Investors like Warren Buffett, who are extremely disciplined about assessing value, will judge that a stock has become very cheap relative to a company’s earnings or potential. For example, if a solid company’s share price had been so high that its dividend yield was only 2%, but then the price suddenly plunges and the yield jumps to 6%, they see that as an opportunity to acquire a large stake at an attractive price and move in with large-scale purchases. As other investors, recovering from their fear after seeing this in the news, return to the market, stability gradually comes back.

Bitcoin, however, is an asset whose price is its value. When the price collapses, confidence in its value collapses with it. The conviction that was supposed to act as a support level evaporates along with the price.