Quantitative cryptocurrency investment strategies
Quantitative hedge funds have been very secretive in the past about their returns and investment strategies. Academic research has sifted through the vast landscape and was able to crystallise core investment strategies that explain the hedge fund performances and have delivered positive long-term returns (see for example here). We have taken the main results and applied the quantitative trading strategies to cryptocurrencies here.
The main idea behind quantitative investment strategies is to actively trade the underlying assets in order to outperform a simple buy-and-hold strategy. These active strategies take full advantage of price fluctuations and try to beat the market. The market is in the case of cryptocurrencies just holding Bitcoin, Ethereum and the other cryptocurrencies with a market cap weighting (see below). Holding the cryptocurrencies makes it very cost-effective, however, it also requires a buy-and-hold mentality and with annualised volatilities (see below) in cryptocurrencies around 100% that is sometimes hard to stomach.
Table: Data from Protos Asset Management as of 4/26/20.
How do quantitative strategies work?
In general, quantitative strategies implement a selection of assets over time. The selection can be changed during the day (up to high-frequency trading) or on longer time horizons like months. Each quantitative strategy is usually driven by a set of criteria that select the assets. Unfortunately it is not easy to find criteria that have a positive effect over long periods of time. Also these criteria are different for different time horizons. Some criteria work only if they are traded very fast during the day like news-driven strategies and other criteria are very slow like value-driven strategies. We have focussed our quantitative strategies on daily to weekly trading as these are some of the best-working strategies across asset classes and have worked for over 100 years (see for example here).
We have recently reviewed the different strategies here and one strategy stands out: trend-following. This comes as little surprise as this strategy is very well known in other asset classes like equities, bonds, FX and commodities.
Example: Trend-following
Trend-following can be considered as one of the core quantitative strategies. Hedge funds deploying this strategy are called managed futures funds or CTAs. Interestingly, their returns can be explained by simple trend-following strategies, specifically time series momentum strategies. Time series momentum is alluding to a general momentum in prices of assets. The idea is that once a momentum of an asset starts it usually continues over several days, weeks or even months. One explanation is that new information about an asset enters the market and the market adapts only slowly to that new information. Hence a momentum can build up and can be used for trading.
We have explained the trend-following strategy for cryptocurrencies in detail here. To summarise, the trend-following strategy buys an asset if the price is up over 30, 60 and 90 days and otherwise stays in cash. The graph below shows the performance of the trend-following strategy for Bitcoin (BTC) versus just holding 1 BTC since the end of 2017 until end of March 2020. In fact, 1 Bitcoin invested over this time period became 3.7 BTC, outperforming a simple buy-and-hold strategy by 266% and reducing risk (measured by volatility) dramatically.
Summary
Trend-following is one of the most prominent quantitative trading strategies for a reason: it worked well over 100 years and in almost every asset class (see for example here). The strategy follows a simple pattern: select an asset if the price is up over 30, 60 and 90 days and otherwise stay in cash. We have applied this strategy to cryptocurrencies and found that it turned 1 BTC into 3.7 BTC (see chart above) and outperformed a simple Bitcoin holding strategy by 266%.
The reason for the outperformance of the trend-following strategy is it participated in market rallies of Bitcoin, but went into cash during bear markets. Therefore trend-following can be considered as replicating a call option (see again here). Call options are financial contracts that give the buyer the right, but not the obligation, to buy an asset at a specified price within a specific time period. This provides a simple pay-off that provides only upside with limited risk. Unfortunately, a call option comes at a cost called the option premium. The same can be argued for trend-following that we discussed here.
