Maximize Bitcoin Gains: The Precision of Trading With Fair Value Deviation
In my previous article, I explained the concept of the power law and how it can be utilized to estimate the fair value of Bitcoin:
In this article, I’ll show how deviations from the fair value can be used for trading Bitcoin. I’ll skip the technical details and jump right into the conclusions.
Procedure for Estimating Subsequent Returns for Different Deviation Levels
The procedure for estimating subsequent returns for different deviation levels can be summarized as follows:
1. Predict the fair value of Bitcoin by using the power law for each date.
2. Compute the deviation from fair value and the percentile rank of that deviation among all the deviations recorded up to that date.
3. Use the percentiles to find the deciles that deviations fall into. The 1st decile corresponds to the maximum negative deviations (current price below the fair value) whereas the 10th decile corresponds to the maximum positive deviations (current price above the fair value).
4. Compute the average, median, minimum, maximum, standard deviation, and Sharpe ratios (assuming a zero risk-free interest rate) of the subsequent weekly/monthly/annual returns for each decile.
Here are the results:
Subsequent Weekly Returns
The results are startling. The highest average weekly subsequent return is attained when Bitcoin is most overvalued, i.e. in the 10th decile.
Momentum is much more pronounced than mean reversion in the short term.
On the other hand, higher returns come with higher risk. The maximum and minimum weekly returns belong to the 10th decile. Yet, risk-adjusted returns are among the highest as demonstrated by the Sharpe ratios in the last row. The Sharpe ratios of the 7th and 9th decile are also as high as that of the 10th decile.
Hence, if you are a short-term trader, trading when the BTC is overvalued is more profitable.
Subsequent Monthly Returns
The highest average monthly subsequent return is attained when Bitcoin is most undervalued, i.e., in the 1st decile. On the other hand, the risk-adjusted returns are considerably higher for the 7th and 8th deciles, with Sharpe ratios of 1.44 and 1.38, respectively. The 8th decile also has the highest median return which is more than double the median return for the 1st decile. Average returns are positive for all deciles. It is worthwhile to note that the median returns are negative for the 9th and 10th deciles although respective average returns are large positive figures.
It appears that momentum still prevails in the medium term, although mean-reversion starts to kick in.
Subsequent Annual Returns
Although the highest average and median annual subsequent returns are attained in the 5th decile, the highest Sharpe ratio is achieved in the 1st decile.
As the investment horizon gets longer, entering into long positions in the most undervalued decile generates the highest risk-adjusted returns, which is a stronger manifestation of mean reversion.
It Makes Sense to HODL
It is also important to emphasize again that all average weekly, monthly, annual subsequent returns are positive, which can be summarized in layman’s terms as: it makes sense to HODL.
There are further insights to be gained from the Bitcoin Power Law, which will be the subject of the next article.
