Cryptocurrencies are hot and volatile. Paul Cretien provides a strategy to access the sector without opening yourself up to the extreme risk it has exhibited in 2018.
For pairs trading it’s best to use two assets that have the same economic or market base that determines their prices and price volatilities. For example, Stocks, futures, options, fixed income, exchange trade funds or foreign exchange. It helps if one of the asset classes has more price volatility than the other, but this is not required. Over time, we should find periods when one asset class — the one that is more volatile — is priced relatively high or low versus the one that is less volatile, or relatively stable.
The chart below shows the price changes for six well-known virtual currencies from January 2018 to January 2019. Two things are obvious: First, 2018 was not a pleasant time period for investors or speculators in cryptocurrencies, unless they were able to take a short since all six finished the year down more than 60%; second, the cryptocurrencies in this group moved in a well-coordinated way as if all were responding to a single force in their price changes. Since this appears to be a consistent pattern, we will assume that 2019 will show similar correlations for this group of six currencies, as well as for the cryptocurrency market in general.
The price movement of Bitcoin and Ethereum was very close for the first half of 2018 then began to diverge in July, with Bitcoin remaining stable and Ethereum dropping, creating a gap of approximately 20% from Jan. 1, 2018 (see chart below) . This divergence could have signaled a reversion trade at the height of the divergence in September 2018. A trader might have sold Bitcoin and bought Ethereum, expecting to profit when the two currencies erased the gap in their price changes.
Over short time periods, we might expect the stable asset – for example, Lite Coin vs. Steller Lumens (see chart below) — to remain calm and not change drastically. With this assumption it would be possible to profit more by simply buying or selling the volatile member of the pair and expecting its price to move in the direction of the asset with the more stable price. This technique depends on the distance between the volatile and stable members of the pair to show the possible profit from buying or selling the asset that is more volatile. It is a basic reversion trade.
One reason why the new approach – trading only the more volatile member of a pair – should be profitable is that all of the currencies are moving together. This correlation is more than a pair, it is a cryptocurrency crowd. Bringing the volatile currency back into line could be called “crowd control.”
Cryptocurrencies represent an anomaly for traders. They want access to a hot and volatile market, but they are afraid of the volatility. Pairs trading of cryptocurrencies may be the answer. They can take a position in an outlier currency and hedge with a more stable crypto. This way they can access investing in a new and exciting sector, without buying the sector.