2 Sigmas: Risk Mitigation Strategy
Lesson N: Being Devious with Standard Deviation
In statistics jargon, sigma (σ) is
“The unit of measurement usually given when talking about statistical significance is the standard deviation. . . The term refers to the amount of variability in a given set of data: whether the data points are all clustered together, or very spread out.”
We saw with risk mitigation in a previous article that determining the probability of risk involves analysis of the standard deviation of the data in question. Variation with respect to the standard deviation is measured in sigma.
1.2 Labs employs a “2 sigmas” risk strategy to mitigate loss when investing in cryptocurrencies. This essentially means following the price of an asset and charting its 2 sigmas variation, which results in highlighting a corridor of gain and loss.
Here’s a look at the price of ETH, where the 2 sigmas corridor is in orange highlight:
What’s important for risk mitigation is the lower part of the corridor, which involves a 2 standard deviation drop from the price of the asset. The chart is, of course, a temporal snapshot of the price of an asset. At any point on the chart, you wouldn’t know what the price would be at a future point. (If you did, you’d have a crystal ball for investing!)
Yet at the same time, the 2 sigmas corridor provides you with a sense of how much the asset’s price might drop in the future. I say “might” because you can see on the chart above that there are points where the price dropped below 2 sigmas.
Notwithstanding these occurrences, you can use the 2 sigmas calculation to hedge against future drops. One way you can do this is to purchase put options, which are contracts that earn a profit for the buyer when the asset in question falls below a certain price. Options are quite complicated, and you can learn more about call options and put options in a previous article.
This article is a part of the Crypto Industry Essentials educational program presented by 1.2 Labs (formerly The Art of the Bubble).
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his 1.2 Labs education series on cryptocurrencies.
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