Founder at www.protosmanagement.com. Senior portfolio manager and quant. PhD in Comp Neuro. SU Alumn
With the recent sell-off in global markets, we wanted to take the time to review the performance of our investment strategies in cryptocurrencies and evaluate the risk in them.
What did we learn from last two years of trading?
1. Momentum has largely outperformed all other investment styles, because it participates in market rallies, but goes into cash during bear markets
3. Small cap (altcoin overweight) has outperformed the market initially and then underperformed
Why was momentum trading so successful?
However, the investor in this strategy is not fully hedged when the market sells off. Especially if the market sells off up to 25%, the momentum strategy is still very much affected and only slightly reduces the risk to about 20%. However, the momentum strategy has worked well in larger sell-offs and reduced risk to about 10%. We calculated the average performance of the momentum strategy over 90 days, when the market performance was negative over the same period, to 2.66% and hence 10.66% over 1 year.
If the replication of a call option works well with the momentum investment style what about put options and even selling options?
However, the investor has to pay both the call and put option premium, so the straddle is even more expensive. At Protos we only trade momentum long-only exactly because the put option replication is even more expensive and because we are optimistic about the general market.
What about selling options?
The pay-off profile for a short straddle is just the opposite of the long straddle, which is selling both a put and a call option. In this case, the investor is collecting the option premium. Therefore if the market moves sideways, the investor is generating a constant yield. However, if the market either goes up or down substantially, the investor is facing unlimited losses. That is why we think a lot of funds and investors that implement this strategy, have gone out of business.
If momentum investing is replicating a long straddle, then the opposite of momentum investing should be a short straddle. What is the opposite of momentum investing?
So consider the following market scenario: If the market has already dropped substantially, the momentum investor would go either into cash (long-only momentum investing replicating a call option) or go outright short in this market (long and short momentum investing replicating a straddle). The opposite strategy would of course be to buy this market and feel that the market is cheap and betting on a recovery. Of course if the market continues to fall, then this investor would face potentially unlimited losses. This strategy is called in general a mean-reversion strategy and is applied by market makers. As market makers are always quoting both sides, they are inherently facing the risk that the market continues in one direction and that they cannot close their positions. Another name of this strategy is buying-the-dip and it always has the risk of unlimited losses.
Which strategy is better — momentum or buy-the-dip?
Well that of course depends on the market and the risk appetite of the investor. The advantage of momentum investing is that the downside risk is pretty limited, but on the other hand loses small amounts of money over time if the market moves sideways.
The advantage of buy-the-dip is that this strategy generates usually a yield and increases the holdings slowly over time. On the other hand, this strategy is facing an unlimited loss, especially if the dip is bought multiple times with leverage. Since this strategy is applied by market makers, they usually have good performance for a period of time, but then get wiped out in an unexpected market crash like this one during March 2020 in both equity markets and crypto markets. In fact, we believe this is the reason why there are very large famous hedge funds and not many famous market makers — ultimately they just get wiped out once in a while. Or as the saying goes: “The trend is your friend”.
(Disclaimer: The author is a co-Founder and CIO at ProtosFund)
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