Your One Trade of the Year
We might be divided on this…
Cooking is an enjoyable experience.
Judging from the longevity of The Food Channel, the various cooking contest on TV, food blogs, and the long check-out lines at Crate and Barrel or William Sonoma, it is hard to say the opposite.
What I find fascinating is how big the market has grown around this experience.
Once a person forays into the world of culinary, they are inundated with kitchen appliances and time saving devices.
It might start off with a small purchase… Like a pizza slicer or garlic press. Then, as the confidence builds and more YouTube videos are binged… the ambitions balloon.
Now the trip to the store is centered around specialized devices… Sous vide machine, egg poacher, laser thermometer…
It is not be long before the kitchen drawers and cabinets are overloaded with utensils and gadgets.
Now, let’s take a look at your TradingView window in a similar way to your kitchen. It is a platform where you get overly specialized to dissect, cut, and chop your way through every asset.
You probably get where I’m headed here…
Your TradingView might be cluttered.
Well, today I’m here to offer you something that is much more simple. A way to cut through a lot of the overly complicated features you see coming from various trading channels.
It is something based upon a simple sentiment indicator you’ve likely heard of countless times, and blew off as a click bait item… The Fear and Greed Index.
The Fear and Greed
The Fear and Greed Index is one of the most used indicators in the entire cryptoverse. It simply gives a data point to what everybody in the market is feeling… The market is scary or its like a double dose of dopamine.
And while many know about the index, there are few that have discussed the usability and the potential of it as an investment indicator. After all, it feels nothing more than a click-bait piece.
We decided to take a look at it, and I think you’ll want to take a look at what we found…
Today, the F&G is at 10. As the status reading indicated, the market sentiment is at “Extreme Fear”.
In terms of how the index is broken down, it is seen in the table below.
The index takes in all these factors to distill the tone and the sentiment of the cryptocurrency market. The metric itself goes from 1 to 100. With 1 being the most pessimistic or fear sentiment and a reading of 100 being the most optimistic or greed.
Now, given the tendency of darkness becoming light… change being a constant… and quietness becoming loud… Extreme index readings must revert back to a normal reading.
Which begs the question… Is this something we can act on? Is there alpha here?
Before we answer that question, let’s quickly showcase the frequency of low and high readers via Fear & Greed (F&G) index.
It is Not just Click-Bait.
Let’s first see how frequent various reading are for the index. We broke readings down into buckets. On the far left is the number of occurrences of a ten or lower for F&G. On the far right is extreme greed between 90–100.
As you can see, a reading below 10 is extremely rare. And a reading between 20–30 is the most frequent.
Go ahead and store that tid-bit in the back of your mind.
Next, let’s hit on the Sharpe Ratio.
Sharpe ratio measures the performance of an investment or an asset relative to the riskiness of the asset or portfolio.
Basically, you want a high number. The higher the number, the better the risk-adjusted profit return potential of an asset or an investment.
In terms of actual numbers, a sharpe ratio below 1 is considered bad. Between 1 and 2 is considered good. Between 2 to 3 that is considered very good. Anything above 3 you are stellar. And above 4, you are likely on the cover of every Bloomberg Magazine.
OK, now back to the bucketed items we mentioned before… Assume you purchased bitcoin whenever its F&G reading was in a certain bucket. Then sold it the next day. What would your sharpe ratio be? That’s in the chart below. As you can see the ratio when F&G was ten or below was 8.0.
This is impressive. To provide a little context in terms of how impressive… From 2017 to 2020 there was one hedge fund with a sharpe value over two over that time period. One single hedge fund.
That’s powerful. Which means we probably can squeeze some alpha out of this index.
Let’s grab the juicer…
The sharpe ratio led us to start doing some backtesting of various strategies. The strategy is pretty simple for this example…
Buy when bitcoin has a value of ten or lower. Then sell when the F&G crosses above a certain value. This harkens back to what we mentioned earlier where extreme readings eventually become normal readings — mean reversion.
To see if this idea had merit we picked three values: 35, 50, 65. Meaning we ran three backtesting strategies. In one strategy we measured the returns if an investor purchased bitcoin whenever the F&G was ten or lower, and sold whenever it went above 35. Then the backtest was done again for selling at 50 and then a last one at 65.
The chart below shows this test…
In the top half of the image there is a chart with small purple circles. This indicates when F&G was ten or lower.
In the bottom half of the image the chart shows the returns. The yellow line indicates the returns for the first strategy (buy at when 10 or lower, sell when >35). The orange line is the second strategy (buy at <=10 and sell at >=50). Then red is the third strategy where the investor sells when bitcoin is above 65.
As you can see, the red line performed the worst of the three.
What you may also notice is the first strategy, which is the short-term strategy performed the best with 14.6% returns annually on average. And a cumulative return at 133.4%. It also has the lowest max drawdown risk at -25.3%.
A drawdown risk simply means how much pain does the investor endure once the asset is held.
What we also realize is the long-term strategy results in more risk to a bigger drawdown. That’s seen in the image below.
This means the longer you hold the asset (the horizontal axis measured days), the more pain you might be in for if using only F&G for a trading strategy.
Which means the next time you see the F&G index this low, don’t be so quick to dismiss it.
Thanks for reading!
This essay was brought to you by the team at Jarvis Labs. Team members who contributed to this article were the Bens (Benjamin @Jarvis_Labs_ LLC and Ben Lilly @MrBenLilly on Twitter), Aritra, Jaxson Turley, and Shane Leather. Be sure to subscribe to read more easy to digest quant based work from Jarvis Labs.
Also, special thanks to @quantfiction on Twitter for the inspiration to look into this further. Thanks.