How to mitigate risk in crypto investments or trades



Cryptocurrencies as an asset class are extremely volatile and have often restricted liquidity and represent a higher risk than other investment asset classes. They have also appreciated an extreme value increase in the last years. So, we from Exogneou asset management started our research, by asking ourselves, could a common hedge fund strategy, when applied to the cryptocurrency market, allow us to successfully limit our risk while still participating in the uptrend?


Blockchain assets emerged as a new asset class since the publication of Bitcoin in the year 2013, since then this asset class is traded highly frequent on the various online exchanges (Binance, Crypto.com, etc.). As already mentioned, Bitcoin is the most prominent example and the most valuable at the time of writing with a market cap of more than 896 billion USD.


The total market cap now exceeds 2.1 trillion, which is more than Germany´s debt rate. Including more than 16 thousand blockchain assets. The total daily trading volume exceeds 67 billion USD.


This market seems to face tremendous interest, as some of these cryptocurrencies have increased their market capitalization over 30 times in a short period of time.


For example, Ethereum has increased more than 31 times on the 1/1/20 compared to the 5/11/21. If an investor would have bought 1000 U.S. dollar worth of Ethereum in 2020, he could have afforded to buy himself a new car back then in 2021.



But interest always comes with risk

If we compare the Cryptocurrency market to the stock market, we can see that startups are be able to generate a similar return, especially when they are at an early stage. Most of the blockchains are released by startups which are at an early stage, which leads this investment to significant risk, in this new asset class, because some of these startups will undoubtedly fail, as well as their blockchains.


But risk doesn't end there as some of these assets have restricted liquidity and represent a higher risk then most investments in other asset classes do, for instance stocks, bonds, and commodities. This very limited liquidity results in a massive price increase and sometimes even larger price drops.


In addition, one could fear that the blockchain bubble bursts. In particular the risk, which is measured by volatility, in this new asset class is far bigger than in classic asset classes like equities or bonds. Both Bitcoin and Ethereum have a volatility of more than 100% over the past year whereas the S&P 500 index has a long run volatility of around 16%.



How hedge funds manage their risk in traditional markets

The ideal scenario would be, that one could participate in the upside of blockchain assets such as Bitcoin but, be protected on the downside. In traditional markets one could achieve that by buying a call option.


So, let's dive deeper in this matrix, a call option is the right to buy a particular underlying asset at a certain time for a certain price from the seller. The result is that the buyer of this option is only participating in the upside of the underlying but, not if the price of the underlying falls. Of course, the buyer must pay a fee for that (premium).


The figure below shows the payoff and profit profile for the buyer, depending on the price of the underlying at the expiration date for the call option.



Risk Diminishing Tools Are Limited in Crypto

Unluckily call options are not readily available for blockchain assets there is not yet a provider of these options and options are inherently difficult to trade as well. It does take a lot of time to master trading this type of derivative.


Several other strategies exist to evade financial risk. Fundamental analysis, delving into a detailed analysis of the cryptocurrency such as revenues, adoption level, governmental level, governmental models, development strategies etc.. These might help to find less riskier investments. However, these markets lack the underlying data required to make such judgment with confidence.


So, what tools do we have to limit our risk?



Managed future, foreign exchange, or commodity trading advisors at work

Hedge funds have developed a strategy that is only based on the price history of an asset and works similar or sometimes even better than just buying a call option.


The strategy is called trend following and is in fact one of the largest strategies in the hedge fund space. These Trend-following strategies have existed for over 50 years and have grown to approximately $320 billion of assets under management.



We were interested, if this strategy could actually be applied to crypto trading in order to replicate a call option?

Trend-following strategies have been shown, to have a similar result as call options applied across all asset classes of equities, bonds, Fiat currencies and commodities. The strategy proposes to buy an asset, if the return of this asset is positive over the last m days, we suggest to use m between 30 and 360 calendar days.


We applied this simple Trend-following strategy to the Bitcoin market price and choose m days. We calculated m = (x-t^v) for each day in the past. If the return was positive, we would assume that we would have bought bitcoins. If the return was zero or negative, we assume that we would have not kept a position in Bitcoin.



The Result?

The figure below shows the rolling returns of this strategy for different Bitcoin returns. Since the inception of Bitcoin.


For example, if Bitcoin market price increased 200% over m days, then the strategy made about 200% as well. However, if bitcoin lost 50% in m days the trend following strategy lost on average only 10%.


Our research has shown that trend following strategies from financial markets can be applied to Bitcoin trading.


With this strategy, and investor would have participated in the large uptrends of Bitcoin, but not so much in the drawdowns of Bitcoin of more than 90%.


The strategy returns similar profits, if the Bitcoin price moves up significantly, but does not lose nearly as much in a down market. In other words, this strategy returned a similar profit as a simple Bitcoin investment, but reduced the risk. In statistical terms, the strategy increased the Sharpe ratio by about 50%.



What´s important?

The investor has to pay a price for this protection. First he is to watch the Bitcoin market very closely on a daily basis and has to invest a lot of his time. Secondly the investor does not fully participate in Bitcoin, if the market price reverses quickly. He would sell his position in a sell off, but would only get back into Bitcoin after it has retraced from the low. Thirdly, his risk is not serious if the Bitcoin market sells off, but limited to an average of about 10% and sometimes even higher.


Trading several blockchain assets at the same time would improve the investment performance, this extension to the strategy has been proposed. The most common approach is weighting these investments according to the volatility of each market.

The negative aspect of this strategy is that it does not fare well if the market moves sideways with a high volatility.


This analysis or strategy is based only on price data. Future work should definitely incorporate other technical data and sources, for instance: volume, order-books and maybe also some valuation models to support this strategy from a fundamental view.



Round up:

The extreme risk and high profitability of blockchain assets let us to wonder, if we could apply a common hedge fund strategy to limit our risk, while still participating in most of the uptrends. We tested a common hedge fund strategy called Trend-following, to limit our risk but still participate in the highly profitable trends of Cryptocurrencies.


We applied this strategy to Bitcoin as an example and found out that the strategy works well. If the coin rallied over 200%, the strategy would have returned almost the same. However, if this if this coin sold off 50%, the strategy would only have lost an average of around 10%. This is almost similar to a call option where you only participate in the upside of the investment, but on the other hand side you have to pay a premium. The premium would be around 10% in our example.


Ideally this strategy should be applied on a wide range of different cryptocurrencies to improve and lower the premium even further. Other strategies to mitigate the risk of investing in cryptocurrencies might be to take a more fundamental approach. However, the detailed comparable data across Cryptocurrencies is not yet available.