2018 has been a tough year for crypto investors. Bitcoin has declined by more than 60% and leading altcoins have lost up to 90% of their value. Nonetheless, there are still traders who are making bank in the crypto asset markets despite the bear market.
In this guide, you will discover how you can deploy a market neutral trading strategy to potentially generate a trading profit despite the difficult current market environment.
What is a market neutral strategy?
A market neutral investment strategy aims to profit from both rising and declining prices while avoiding overall market risk. The are various strategies that fall under the umbrella term “market neutral,” such as convertible arbitrage, merger arbitrage, relative value arbitrage and equity market neutral.
In this guide, we will focus on equity market neutral arbitrage and how it can be applied in the crypto asset markets. An equity market neutral strategy involves going long a basket of stocks versus short a basket of comparable stocks to remain “market neutral” so that the investors can alleviate market risk.
For example, a portfolio manager can go long tech stocks that he or she believes will outperform while going short comparable tech stocks within the same sector that he or she believes will underperform to benefit from the price differential of his long picks versus his short picks. As the short and long positions alleviate equity market risk, this creates a market neutral portfolio that can generate a profit regardless of how the S&P500 Index performs.
This strategy is sometimes also referred to as “pair trading” as it can also involve buying one stock and short selling another.
Equity hedge funds and market neutral mutual funds have been deploying this investment since the 1980s.
Market neutral crypto funds have done well
In Q1/2018, when the price of bitcoin dropped by 50% from USD 14,110 to USD 7,050, two hedge funds managed to generate 30% and 5.4% perfect return on investment respectively due to their market neutral investment approach.
According to Bloomberg, Amber AI Group’s Pivot Digital Trading-2 fund, also known as PDT2, managed to generate a 30% return in the first quarter by avoiding directional bets and instead focusing on a market neutral strategy. BitSpread Group’s Market Neutral Liquidity fund generated a return of investment of 5.4% in the first quarter.
While most crypto hedge funds’ performances are closely tied to the overall performance of the crypto asset markets, market neutral funds are managing to buck the trend and generate returns regardless of the overall market’s performance. Hence, funds like Amber AI’s PDT2 and BitSpread’s Market Neutral Liquidy are able to offer investors a degree of protection during a bear market.
Having said that, it is important to note that market neutral funds will generally not perform as well as funds that are highly correlated with the market during a bull market.
How to deploy this strategy as an individual investor
While market neutral investment strategies are normally deployed by institutional investors, this approach can also be adopted by small investors in the cryptocurrency markets by engaging in pair trading.
A pair trading strategy could be executed involving two comparable digital tokens within the same token sector.
For example, you could go long EOS (EOS) versus short ether (ETH) — using the same dollar amount — if you believe that EOS is the superior platform for smart contracts and dapps (decentralized applications). In this instance, you would benefit from EOS outperforming ETH while overall market risk would be negated. If the market declines, which it has done throughout most of 2018, you would earn a profit on your short position and lose money on your long position. The difference between the outperforming long position versus the underperforming short position, however, you would be able to bank as profit regardless of the direction of the market.
If you would have engaged in a long EOS versus short ETH trade at the start of the year, you would have generated a profit on this position as ether dropped by around 60% while EOS only dropped by around 45% year-to-date.
Alternatively, if, for example, you have done your research on privacy-centric digital currencies, you could enter into a trade where you buy Monero (XMR) and sell Verge (XVG). Both are comparable assets as they are both among the most popular anonymous coins. However, most crypto investors would argue that Monero is the better project.
Hence, a long XMR versus short XVG pair trade would be another example of a market neutral position that anyone could put on. If you would have put this trade on at the beginning of the year, you would have made a profit as XMR dropped by 75% while XVG dropped by almost 95%.
Instead of pair trading, you could also choose a basket of coins or tokens you want to go long versus a basket that you want to go short.
For example, remaining in the anonymous cryptocurrencies realm, you could go long the three privacy coins with the largest market capitalizations (Monero, Dash, and ZCash) versus the three with the next largest market capitalizations (Verge, Komodo, and Horizen (previously — ZenCash) provided you believe that the market value of these projects accurately reflects their future potential.
The investment horizon of market neutral trades can be short or medium-term, depending on your personal preference and overall investment approach. Over the long-term, however, shorting one or more crypto assets could become too costly. Hence, it is more of a short to medium-term trading strategy.
Things to consider when pair trading crypto assets
Before executing a market neutral strategy such as pair trading, there are a few things that crypto investors need to consider.
Firstly, the two pairs in question will need to have a high positive correlation. That means they will need to move in tandem as the market moves. If the two chosen assets do not correlate, buying one versus selling the other will likely not result in the desired returns.
Secondly, trading fees need to be taken into consideration as well as the lending fee for short selling. As this strategy is more trading intensive than buying and “hodling” a portfolio, fees play a role as they reduce profits.
Thirdly, the most important aspect is to identify the right comparables to make this strategy work. For example, pairing up a utility token of a smart contract platform with a reward token will not make for a good trading pair. Hence, it is important to look in detail at the comparables you want to trade and to research each project thoroughly so that you can identify which one you should go long and which one you should go short.
Finally, it is also important to note that this strategy involves a certain degree of active involvement. Hence, it is more suitable for those who have the time to check in with their investments on a daily basis and have the time to research projects thoroughly before investing.
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