Not Sure Where Crypto Is Headed? Consider One Of These All-Weather Crypto Investment Strategies
Most buy and hold crypto investors might aim to “shoot for the moon” but in reality there exists a subset of crypto investment strategies that can work regardless of market direction with a different risk/return profile.
So given my interest/focus in the area of market neutral cryptocurrency trading strategies, I thought I would share some of the generic strategies that I know of. For those interested I will also show how crypto and non-crypto (fiat) investors might be able to implement it for themselves.
To be consistent each section is broken down by strategy covering:
- Basic concept of the strategy
- Return profile of the strategy
- Risks/things to consider
- Implementing this in practice
- For current crypto investors or investors looking to get crypto exposure
- For current non-crypto (fiat) investors (that don’t want exposure in crypto)
As a fan of TL DR, mine is below (though I would recommend reading the details to get a better sense):
Lending out Cryptos/Fiat:
Fairly easy to manage and can produce a stable return. Main concern is exchange default risk but overall fairly easy to implement for both Crypto and Fiat investors.
Can produce a stable return but requires active management which can make it a hassle (and not worth your time). Also cannot be implemented for crypto investors.
Arbitrage (Cross Exchange Arbitrage)
Has potential for decent returns but requires in-depth knowledge and active management in order to maximise. Can be implemented by crypto or fiat investors.
Invest in Proof of Stake (POS) Coins
No efficient way to hedge out crypto exposure hence making this strategy difficult to implement for fiat only investors. Only really feasible for crypto investors that already intend to invest into these coins because the coin’s appreciation/depreciation should be the primary concern.
Lending Out Cryptos/Fiat In The Crypto World
Just like lending money out to earn interest, you can also do the same within the cryptocurrency space. Similar to money lending returns may not be as glamorous as speculating but it can be much more stable and consistent.
Generally demand for borrowing cryptocurrency come from traders who:
- Want to borrow cryptos to short sell
- Want to leverage their investments such as borrowing BTC to buy ETH
So in order to facilitate this demand, some exchanges offer the service to lend out your cryptocurrency (or even fiat such as USD) at a daily interest rate. This allows HODLers to lend out their cryptos to earn some extra income whilst allowing traders to punt on the market using leverage.
The returns in a crypto lending strategy can vary depending on market condition. For example if there is a strong bearish sentiment then it becomes increasingly harder to borrow cryptos for short positions which in turn increases the borrowing rate so lenders can receive a more favorable rate.
The rates itself are priced daily so annualize performance can fluctuate a lot depending on what rate you can lock in and assuming you are able to maintain fully deployed. Below are some of the current rates as of this moment:
Risks/Things To Consider
So what are the risks associated with this strategy?
The main one would be exchange default risk. This is the risk you get by having to leave your funds on the crypto exchange platform since you need to use the exchange to lend out your crypto. This means if the exchange goes bankrupt (defaults) then your crypto holdings would be at risk. (I will cover more detail of exchange default risk in a future article)
Another risk would be that in some cases you won’t be able to call back your loaned out cryptos during the duration of the loan. This means that you won’t be able to sell your cryptos whenever you want and as such can pose a risk (an opportunity cost) when the markets are volatile.
Implementing This In Practice
This is a fairly simple strategy to execute as there are exchanges that offer lending (or margin funding) which make it easy for you to set your own lending rates and execute the “trade”. However this service is only offered by select exchanges, which means you would have to be comfortable with depositing with them:
- Liquid formerly known as QuadrigaCX
Note: This is merely factual and not a recommendation/endorsement of any of these exchanges.
For Crypto Investors: In this case you would simply be lending out the cryptos you hold. Your returns would then be based upon the demand people have on borrowing your cryptos as you receive interest. You will still have the underlying crypto exposure and can still sell your cryptos whenever you wish (as long as it is not locked up in a loan).
For Fiat Investors: Investors that don’t want to have crypto exposure can take advantage of this opportunity by putting on a hedge on the crypto they buy or simply just by lending out fiat (Bitfinex offers USD and EUR) on the platform. From my experience lending in fiat is usually more profitable than doing the complicated hedge variant but if you do still decide to go for the hedging option just be sure to check that the lending rate your receive after fees is greater than the hedging cost you pay.
As per Wikipedia, “Basis trading is a financial trading strategy which consists of the purchase of a particular financial instrument or commodity and the sale of its related derivative (for example the purchase of a particular bond and the sale of a related futures contract).”
So how do you make money from employing a basis trade strategy? Using futures contract as an example, you will often see that in the crypto (and finance) market there is a premium/discount associated with the futures. This means that if you were to hold the futures contract and the equivalent position you could potential make a return on this.
Example (using bitcoin as an example):
If bitcoin futures were trading at a premium at $6,300 versus bitcoin priced at $6,000
- Buy Bitcoin, price at $6,000
- Sell Bitcoin Futures trading at a premium, priced at $6,300.
- When the futures expire sell the bitcoin.
So profit before trading fees = $6,300 — $6,000 = $300
This post on Bitmex explains this type of trade in more detail.
As you may have figured out this strategy will in effect hedge out your crypto exposure hence making it only suitable for fiat investors. Returns on this type of strategy can vary depending on the market sentiment at the time. For example as of writing the December 2018 futures are only at around 0.3% annualized discount which does not make it very appealing. But I have seen this number be significantly more substantial during times of high volatility that can be in the low teen ranges.
In my opinion the biggest “practical” risk is ensuring you have enough funds to maintain your futures position (i.e. margin) whilst at the same time holding the necessary crypto assets. This is particularly difficult for cryptos given its volatile nature which means that margin calls can and do happen easily if you are not careful.
Exchange default risk (aka counter-party risk in this case) is also an issue given that if either your crypto holdings or your financial derivative position defaults then it could provide an unforeseen risk.
In addition the use of financial derivative introduces a level of technical complexity to this trade which adds to the risks. Therefore I would advocate that you need to have some technical knowledge and actively monitor your positions to avoid margin calls etc. to pull this strategy off.
Implementing This Strategy
You would need access to both a crypto financial derivatives and crypto itself to pull this trade off. The more famous financial derivatives exchange are:
- CME — offers bitcoin futures
- CBOE — offers bitcoin futures
- Bitmex — offers a variety of crypto financial derivatives.
How it works was show in the diagram here and there is more detail in this upcoming article which provides step by step instruction on how to implement this.
For Crypto Investors: Crypto investors won’t be able to take advantage of this opportunity because of the fact that you would want to maintain your crypto exposure. Hence employing this strategy would in essence hedge out your crypto exposure.
For Fiat Investors: Fiat investors could put the trade on as described since the inherent nature of holding crypto with the futures should provide the appropriate hedge. There are also a variety of financial derivatives you can consider such as perpetual swaps (offered on Bitmex) that could add a different return profile. However if you are trying to do this with other financial instruments, then you will need to ensure you are fully hedge. Consideration of this is beyond the scope of this article but a degree of financial knowledge would be needed. (I will cover more details on hedging in a future article).
This is where things get interesting (and also what I am most interested in).
Quoting Wikipedia, “Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.” In its simplest form it is simultaneously buying something, say bitcoin, on one exchange that is pricing it lower and selling it on another exchange that is pricing it higher to earn a profit.
There are many variants to this type of strategy in which I will cover in a future article. But to illustrate how this can be done I will look at one of the simplest form of arbitrage in the cryptocurrency space which is the cross exchange arbitrage.
Cross Crypto Exchange Arbitrage
Cross crypto exchange arbitrage is the act of buying a cryptocurrency on one exchange and selling it simultaneously (or in this case as quickly as possible) on another exchange. The most traditional way to do this would be:
- Deposit money into exchange A (the lower priced exchange)
- Buy your crypto on exchange A
- Transfer the crypto from exchange A to exchange B (the higher priced exchange)
- Sell the crypto on exchange B making a profit.
- Withdraw your money from exchange B so you can repeat from Step 1 again.
Profit = Price sold on exchange B — Price bought on exchange A
This method has worked in the past where the most famous case was that certain Korea exchanges were pricing bitcoin and other cryptos at a premium to non-Korean exchanges. Hence arbitrage between the two could reach 10% or more and this was known as the “kimchi trade”. However this method could only work if you were a Korean resident as it was hard for foreigners to open a Korean crypto exchange account as well as get your money in and out of Korea.
Typically though, arbitrage trades generate a small return only which make them not really worthwhile unless you are able to do this at scale such as via automation or you have a unique advantage to help you earn larger a profit per trade (such as the example of the Korean exchanges).
Risks/Things to Consider
You may notice that the suggested method doesn’t actually buy and sell the crypto simultaneously which means there are brief moments of exposure (or lack of exposure) that you do not wish to have which is one of the major drawbacks of this method.
Another issue is that having to deposit/withdraw money that frequently means you run the risk of your assets getting frozen somewhere along the way either by an exchange or by the bank. One of the most likely situations would be that a bank might suspect you for money laundering and freeze your assets.
Lastly as with all strategies that involve trading on exchanges, there is always exchange default risk so you need to be careful of which exchanges you use as some smaller exchanges might have higher arbitrage returns but have a much higher risk of default.
Implementing This In Practice
This method can work as long as you are comfortable in taking the short term exposure/lack of exposure when you transfer your money between the exchanges. There are also ways to work around this that I can’t disclose (as our company uses it) but all of them have other drawbacks as well.
Also this method usually works well if you have some sort of operational/structural advantage. For example if you owned a Korean crypto account and could move money in and out of Korea efficiently than you could capitalize on the “kimchi trade” described above. Alternatively, in my view, you would have to build automated systems to capture these opportunities at volume to make it add up.
For Crypto Investors: To implement this whilst maintaining your core exposure to cryptos can be done by depositing in your core currency, such as bitcoin, and make your arbitrage in pairs against it. For example you could trade ETHBTC by buying ETH using your BTC on the lower priced exchange and selling it back to ETH on the higher priced exchange.
For Fiat Investors: You would simply be implementing this as per the suggestion above and take on the short term cryptocurrency exposure. Alternatively you could try to hedge out your cryptocurrency exposure but more often than not your cost of hedging would be greater than the profit you can make on the arbitrage trade.
Invest In Proof of Stake (POS) Coins
I have included this section as well since in theory you can invest in POS coins and hedge out your exposure making you market neutral. However in practice it is extremely difficult to find a cost efficient way to hedge and that often the yield you get from investing in POS coins is less than the hedging cost (making this strategy unprofitable). Nonetheless I have included this in for reference/completeness.
Proof of Stake (POS) coins offer a steady dividend type return from simply holding the coin. I won’t go into detail of how it works (as that could be a lengthy article in itself) but in essence you could expect to get a recurring income by holding these cryptocurrencies.
Some example of Dividend Coins/Proof of Stake (POS) Coins:
Note: This is example of POS coins and is in no way my recommendation for these type of coins.
The return on these coins vary significantly depending on the coin you wish to hold. Generally they go from low single digit up to low double digit returns per annum and that these returns are as passive as they come.
Approx. annual return of some of these coins for reference:
Note that some coins (such as DASH) do require you to run a masternode in order to get the payout returns which you can set up yourself or alternatively you could look for a pooling service that you could utilize for a fee (setting up one yourself will also have some cost to it).
Risks/Things to Consider
So the major drawback to this approach is that you would have to be holding these coins which means you would be subject to their price movements. You could try to hedge out your exposure but given the low yielding returns it is unlikely you can remain profitable after hedging costs. Hence you would need to have a positive view on the price outlook of these coins to make it a possible consideration.
In addition running masternode in order to earn the “rewards” has another set of consideration from a cost and risk perspective. The criteria to running one can vary significantly between cryptos hence I won’t delve too deeply into this topic at the moment.
Alternatively if you choose to use a masternode pooling service, then do note that you would be opening yourself up to another area of default risk which needs to be carefully considered as this could vary upon the way your pooling service is set up.
Implementing This In Practice
Implementing this can vary as it depends upon which coin you wish to invest into especially when hedging it may not be a viable option.
For Crypto Investors: If you are already holding these coins I am sure you are aware of these benefits already hence I won’t go into the detail. If you aren’t holding these coins, then I would suggest to do your own research/due diligence before making an investment into them.
For Fiat Investors: Not really viable for fiat investors as explained in the risk section above.
As you can see “shooting for the moon” is not the only strategy in the cryptocurrency world and I am sure there are others that I have not covered.
However most of these strategies require active management and an understanding of the the risks behind it. The effort required to implement the strategies may seem unattractive compared to the potential return (unless you are managing substantial amounts of money/crypto). Nonetheless this hopefully broadened your horizon and has given you some food for thought.
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