Cryptocurrencies are amongst the hottest topics in the financial world. With a social media post about Bitcoin every 3 seconds of the day, it is impossible to avoid the hype. Despite the immense rise in popularity and adoption of cryptocurrencies in general, the industry is still in relative infancy.
It has now been over 10 years since the publication of Satoshi Nakamoto’s paper “Bitcoin: A Peer-to-Peer Electronic Cash System”. BTC has come a long way, as it has traded anywhere in the range of $0.008 up to $20,000 and has been recently bouncing between $10,000 to $12,000. This is a clear sign about the uncertainty surrounding the cryptocurrency market and the constant turbulence in the price. Recent bull movements in the price of BTC are showing some signs of some relative market stability. Investors still see market fluctuations as huge profit opportunities and explains why so many are still seeking to harvest gains.
While the cryptocurrency market has not regained the astronomical $700 billion total market capitalization posted in January 2018, the overall trend over the long-term is still going upward. Other indicators beside market capitalization point to greater adoption as more investors of all kinds look to create profits in the cryptocurrency market. With more historical data now available, traders are now more in tune with price movements and how to predict them and capitalize on them. The volatility may not be as great as it was during BTC’s wild ride to $20,000, there are still ample profitable trading opportunities, both long-term and short-term.
How to overcome risks and choose the most appropriate trading strategy?
When choosing a trading strategy, one has to decide what is the ultimate investment goal. Then you can determine the duration of the investment, the risk profile, the entry and exit times, trading volumes, etc. In order to be able to choose the most appropriate strategy and achieve the investment goals a trader should take into consideration the following:
Risks associated with cryptocurrency trading.
Apart from being a very profitable niche, the cryptocurrency market is known to be one of the riskiest as well. Due to constant price fluctuations, traders are often exposed to the risk of a decrease in the value of their portfolios. Ensuring adequate risk management is further complicated by the fact the digital currencies market is relatively young and lacks the needed historical data to allow traders to build sustainable models. Another obstacle contributing to the complexity of cryptocurrency markets and destabilizes the existing patterns is the constant increase in liquidity. The constant increase in the number of traders also is a factor.
Some crypto assets can’t be converted directly. For many, you must buy Bitcoin to serve as a bridge between the assets to be traded. In such case, you will be involved in two trades, both of which will incur a fixed fee. For most exchanges, the fee is set at 0.25%. Take this into consideration when choosing your strategy so that trading costs don’t reduce profits.
Another variable to bear in mind when starting cryptocurrency trading is the minimum trade sizes for each exchange. $10 in BTC for example. This can make it more difficult for traders who rely on small market swings to capture profits.
The most popular cryptocurrency trading strategies.
A market as dynamic as cryptocurrencies requires flexible strategies allowing traders to maneuver under constantly changing conditions. A few years ago when the cryptocurrency market was in early stage, traders were struggling to discover the main drivers behind a specific instrument’s price. Over time, market participants learned how to identify and exploit relevant patterns and then accurately tailor their strategies. The process of market exploration and testing of different trading methodologies has helped highlight the most successful ways of making money on the crypto market.
Here are the most popular trading strategies that cryptocurrency investors employ:
The HODL strategy
Over the last 10 years this strategy has established itself as one of the most popular and successful trading methodologies. Traders love it because it is simple, quick to deploy and maintain, and cost effective.
The HODL strategy was introduced as the first investments in Bitcoin were made. First, it was referred to as “Buy & Hold”. Eventually traders renamed the strategy to HODL due to a spelling error. Ever since the first cryptocurrency trades took place the popularity of this trading approach has been constantly increasing. Today it is the most widely used strategy in the crypto investing world.
The nature of the strategy
Similar to the “Buy & Hold” strategy when trading stocks or ETFs, the HODL strategy indicates that an investor believes in the potential of the given instrument (or the entire market) and wants to benefit over the long term. This strategy helps traders avoid two of the most widely-spread tendencies in the digital era: FOMO (the fear of missing out) and FUD (fear, uncertainty, and doubt). This minimizes the risk of buying high and selling low.
Who should apply it
The HODL strategy is suitable for different types of market participants:
Investors interested in new ICOs/STOs and their significant growth potential.
Passive investors who do not have the time needed to analyze charts and fundamentals and trade on a regular basis.
Investors who believe in the future growth of the cryptocurrency market.
Novice traders still learning to time market movements.
How to apply it
The idea of the strategy is to find one or more suitable cryptocurrencies where potential is present and then invest. Although the cryptocurrency market tends to be very volatile, the nature of this strategy suggests that the trader should stick with the instrument through both bearish and bullish trends. The reason to hold an asset in a downward trend is based on the idea that it is just short-term momentum and the overall market movement will always be upwards.
Many traders prefer to enhance the HODL strategy with some technical indicators like Moving Averages or Bollinger Bands. These allow traders to foresee the downward trend and to sell the instrument at a high price. They can then capture higher profits and wait for the market to hit another low point, where they can buy low and repeat the entire cycle.
As simple as the HODL strategy is, it still confuses some traders.
The most complicated part is figuring out how long to hold an instrument. Consider the following scenarios and decide which matches your mindset:
Investing a small amount to taste the market:
If you are a novice trader and do not know anything about the market, choose a few coins and focus on them. Do a little research and find out more about each one – what drives their price, where are they traded, what correlations they have, how liquid they are, etc. Then choose the one or two with the highest potential to grow in a year and invest a small amount. Hold them for the next year and repeat the procedure to analyze the performance of your investment.
Investing in sustainable ICO/STO projects:
Find out about exciting, yet tangible ICO projects that have huge growth potential. Enter them at an early stage. Wait for the ICO to catch the initial boom and then re-analyze the market potential. If it is present, hold it. If you find more attractive ICOs, sell and reallocate your funds in the new project.
Figure out your desired profit, buy low and HODL until reaching:
One of the most important things in trading is deciding when to buy and when to sell. Begin with the end in mind. Decide ahead of time what price you want to sell your coin. Then purchase the asset when it dips and the price is lower. Enter a trade and hold the instrument until it reaches the price levels set as your target.
Rebalancing Diversification and Allocation are at the core of a successful investment strategy.
Rebalancing is the engine that keeps the whole process running. Rebalancing is considered by experts as one of the most efficient hedging solutions against the risk of constant market dips. This strategy is applied by various types of traders who maintain a diverse portfolio of assets.
Rebalancing has been around for decades and used by savvy stock and futures traders. Rebalancing is now a very popular and proven way to capture profits and distribute the investment capital among a portfolio of cryptocurrencies.
The nature of the strategy
The rebalancing strategy has its roots in the MPT (Modern Portfolio Theory). The essence of the methodology is to rebalance your portfolio on a regular basis by allocating capital among different assets with pre-set thresholds. This allows you to manage your risk exposure effectively, while at the same time maximizing the investment returns of your portfolio.
Who should apply it
The rebalancing strategy is suitable for:
Investors who can’t or don’t have the time to predict daily market swings.
Investors who seek a simple and efficient way to profit from the crypto market.
If you want to taste the market and create a portfolio with a small initial investment, then the rebalancing strategy may not be your best choice. The periodic rebalancing creates additional trading costs. For each asset that you buy or sell, you will have to pay a fee. For most exchanges, the standard fee is approximately 0.25%, while for others it might be as high as 0.50%. If you are starting with a small initial capital or prefer rebalancing on a less frequent basis, it is better to consider the HODL strategy.
How to apply it
The first step is to create a portfolio of assets. In the case of cryptocurrencies, each coin that you would like to invest in will be considered as a separate asset. The next important stage of the trading process is to determine the percentage of your capital that you would like to allocate in each asset in your portfolio. The example above indicates the allocation of each coin (as a percentage) in the total value of the portfolio. In this case, the investor has decided to allocate his capital equally among all assets, so that each coin represents 20% of the total value of the portfolio.
This is the primary goal that the investor has set. When a certain coin’s value exceeds or falls below the pre-defined thresholds, the investor should rebalance. The idea behind the strategy is to maintain the value held in each asset under the initially specified amounts. The rebalancing strategy allows investors to take advantage of price fluctuations.
When there is a boom in the value of one coin, the gains are then equally redistributed to the rest of the assets in the portfolio. The rebalancing strategy allows the investor to net positive gains by splitting them among the whole portfolio. This captures profits and ensures an efficient hedge in case the price of the coin that has experienced the boom drops.
There are two main types of the rebalancing strategies: Periodic Rebalancing and Threshold Rebalancing.
The easiest way to apply the rebalancing strategy is based on time intervals. Due to the dynamics of the cryptocurrency market, the constant price fluctuations and market swings, investors prefer to perform periodic rebalancing on a daily basis. The profits that are gained every 24 hours are redistributed equally among other assets until the percentage value of each coin in the portfolio is in accordance to the pre-set thresholds.
Threshold rebalancing takes portfolio rebalancing one step further by allowing investors to rebalance their portfolio only when it really matters. This leverages a concept of Allocation Deviation Threshold which determines how much the assets/coins have deviated from the original target allocation as a whole.
Many platforms calculate threshold rebalancing in different ways but, in order to make it easier for our users, we have used a simple approach that is easy to understand and calculate. Let’s apply this to the same example above with the same 4 coins and the same 25% allocation.
For this example the Allocation Deviation threshold will be 10.
When the market price moved in our example above we ended up with this asset allocation:
To calculate Allocation Deviation simply add the absolute difference of each coin’s current allocation percentage from its target allocation percentage.
BTC — |30–25| = 5
ETH — |20–25| = 5
LTC — |22–25| = 3
XRP — |28–25| = 3
The Allocation Deviation realized: 5+5+3+3 = 16
This result is higher than the Allocation Deviation Threshold we set at 10. This outcome would trigger the portfolio rebalance to execute. If the Allocation Deviation was less than 10, the portfolio rebalance would be skipped for the time being.
This strategy helps investors minimize the need to run less profitable rebalancing actions and help reduce transaction fees. Extensive backtesting has shown that threshold rebalancing outperformed rebalancing on a set, periodic basis. Using an Allocation Deviation Threshold of 10–15 generated the best overall results.
HODLing vs Rebalancing
Both strategies have their pros and cons and are preferred by various types of investors. If you can’t decide which one suits your investment goals, a good idea is to run a backtest and compare the performance of both strategies against each other. Backtests are based on historical data and help you track the performance of a specific investment strategy, should you have applied it in the past.
There are various ways to perform a backtest – financial analysts and data scientists use R Python or other programming languages. Capfolio provides an advanced Backtesting Tool within its platform to test multiple strategies against HODLing allocation as well as HODLing Bitcoin.
Here is what we used for our backtest data -
Initial Amount - $10,000
Start Date - Dec 16, 2018 (When market was at its peak)
Asset Allocation - Top 5 MarketCap (BTC, ETH, XRP, BCHABC, LTC)
Rebalance - Every day with Allocation Deviation Threshold of 10
The backtest results
After we run the test, the results reveal that the rebalancing strategy significantly outperforms HODLing.
Rebalancing outperforms HODLing
***Even better results were achieved when Backtest was performed from November 1, 2018 till date when the market was much below the peak.
The truth is that the cryptocurrency market is a complex and hostile environment, even for experienced traders. Depending on the trading style, the significant levels of volatility can provide both obstacles and opportunities. The most important thing before entering the crypto market is to define your investment goals and find the strategy that has the highest chance to achieve them.
Everyone has heard about those early Bitcoin investors with an initial purchase of $5 in BTC that turned into millions. On the other hand, there has been plenty of hype that recently misled investors to incur significant losses. Focus on the three main factors that can make you successful in the cryptocurrency market: Careful and adequate risk management, thorough research, and a well-tailored trading strategy.
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