Crypto markets are going through another bear market. Almost anyone can make money in a bull market, but falling prices tend to separate the wheat from the chaff. The good news is that this also creates opportunities for both traders and investors. Traders who are bold and skilled enough to run short positions can generate significant returns in a downturn. Investors with patience get great entry prices for new positions or to add to existing positions.
1. Position sizing
To stay in the game you must not have positions that are large enough to ruin you. Nobody blows up because they are wrong with an appropriately sized position. You blow up because you are wrong AND your trading position is too large. Related to leverage →
Unless you have years of professional experience with leveraged trading instruments and very solid risk management, do not borrow money to trade and invest in liquid assets. It almost always ends in tears. Read the book When Genius Failed: The Rise and Fall of Long-Term Capital Management
You have a nicely diversified portfolio. But what if most of your positions are highly correlated? Then you really just have one large position. And correlations change. Measure and control for correlation in your portfolio every day!
Do you understand correlation? If you think the returns of the two stocks shown below are highly positively correlated then you would be wrong. They are in fact very negatively correlated (-0.99). Intuition almost always fails when thinking about correlation.
A high volatility / high return portfolio is most often evidence of luck. A low volatility / high return portfolio is more likely evidence of skill. Measure your performance with the Sharpe ratio or similar risk-adjusted metrics and not only by looking at % returns.
5. Relative value
Trading ratios or spreads between instruments (e.g. ETH / BTC) is a great diversification tool because they are often pretty uncorrelated to the overall market. Like individual instruments, these pair trades can be based on strategies of →
6. Trend or mean-reversion
Which of these two “regimes” currently drives asset prices? Are they trending — i.e. up- or downtrend? Or are they range-bound, i.e. will prices revert to their mean? (Understand the concept of cointegration before you put on lots of mean-reversion trades!)
7. Taking profit
This is often as difficult as cutting losses and a key part of risk management. Set a target price (which could be a moving one, e.g. a trailing stop). Anecdotal rule: If you start boasting to your friends how well a position does, it’s often the best time to take profit.
8. Measuring returns
I mentioned the Sharpe Ratio before — it’s key. It captures mean and variance, the first and second moments of the return distribution. But do you also understand the third (skewness) and fourth moments (kurtosis) of your returns? E.g. short volatility strategies tend to have a good Sharpe Ratio but negative skew in their return distribution meaning many small profits and very few massive losses that can wipe you out completely. Always consider the Sharpe Ratio in conjunction with skew and kurtosis.
9. Mistakes to avoid
(a) Repeating a trade because it worked last time — a bit like the general who prepares to fight the last war again. Do your research every time and check if you assumptions and models are still correct or at least reasonable. (b) HODL’ing too great a share of your assets. Only be invested in crypto with an amount you can afford to lose.
Please add your insights in the comments below. If you have questions you can contact me on Twitter (@MarcelDietsch)
Disclaimer: This is not investment advice.