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January 9, 2019

Well-Known Profitable Trading Strategies. Application to Cryptocurrency Markets.

Cryptocurrencies possess unique characteristics of both risk and return and their value-driving factors are not similar to traditional currencies and commodities.

Cryptocurrencies are becoming increasingly attractive to long-term investors. Historical correlation analysis shows that cryptocurrency returns are unrelated to traditional financial markets, which makes them attractive to long-term investors for risk diversification purposes. In addition, high historical returns continue to spur global demand from investors, especially, in cryptocurrencies with the highest market capitalization and liquidity, such as Bitcoin and Ethereum.

Similarly, cryptocurrencies are becoming increasingly attractive to short-term traders. Retail traders can benefit from trading cryptocurrencies due to variety of factors, including: high intraday volatility, tight spreads, the ability to trade short, and access to financial leverage.

However, in order to trade cryptocurrencies and, hopefully, generate positive returns on invested capital, traders and investors need an effective trading strategy (trading system). Therefore, application of both fundamental and quantitatively oriented models for cryptocurrency analysis remains a topical subject in traders’ community.

For this purpose, we examined traditional trading strategies and models, and determined the most suitable approaches to cryptocurrency analysis. We found out that an advanced trading strategy for cryptocurrency markets represents an integrated approach to market analysis that incorporates fundamental, technical and sentiment factors and appropriate risk management tools.

In this article, we are sharing our primary conclusions.

1. Understand the Demand-Driving Factors for Cryptocurrencies

Fundamental analysis of cryptocurrency markets is materially different from other asset classes. Cryptocurrencies do not have underlying financial statements or an income stream, as compared to stocks or bonds. Therefore, valuation models cannot be used to derive their fundamental values. In addition, cryptocurrencies are not affected by macroeconomic indicators and government monetary policies, as compared to forex markets.

Instead, fundamental analysis of a particular cryptocurrency consists in understanding of fundamental factors driving the demand for this cryptocurrency, and, therefore, its mainstream adoption.

For example, understanding what drives the demand for Bitcoin and how its price has changed historically with respect to those driving factors will help a trader estimate a range of fair values. Those estimates can then be used as a basis for making trading decisions. In particular, evidence exists that the Bitcoin market price has a strong positive correlation (linear dependency) with the following variables:

  1. The total number of unique addresses used on the Bitcoin blockchain;

  2. The number of daily Bitcoin transactions; and

  3. The hash rate of the Bitcoin network (i.e. total mining hardware capacity).

All of these variables suggest that the price of Bitcoin directly depends on the activity within the network (i.e. on Bitcoin adoption). Based on this evidence, Bitcoin valuation models have been developed.

Therefore, understanding the fundamental variables driving the demand for a particular cryptocurrency leads to more accurate price predictions, which is a component of a profitable trading strategy.

2. Follow the Long-Term Trend

Technical analysis is widely used in CFD trading, especially in forex and cryptocurrency instruments (such as Bitcoin CFD contracts and Bitcoin Futures contracts). As far as technical analysis is concerned, it is worthwhile to consider two basic trading strategies, which have historically proven their effectiveness and profitability: The Mean-Reversion Strategy and The Trend-Following Strategy.

2.1 Mean-Reversion Strategy

The mean-reversion strategy is based on the assumption that there is an underlying linear trend in the price of an asset and that prices fluctuate randomly around this trend. Therefore, prices deviating far from the trend will tend to revert back.

Let us consider an example for Bitcoin. Exhibit 1 presents the Bitcoin price for the period from 2011 to 2018 (8 years) on a logarithmic scale (to eliminate the visual effect of exponential growth over the years), with a mean value approximated by the linear regression. Under the concept of mean-reversion, the 70% downward price adjustment for Bitcoin in 2018 begins to look fairly reasonable and expected: In 2017, the Bitcoin price has significantly deviated upwards from its 8-year linear trendline by almost two standard deviations, leading to a natural adjustment towards the mean.


Traders can use different technical analysis techniques for trend identification, such as a linear regression, linear trendlines and channels, and moving averages with different smoothing algorithms.

2.2 Long-Term Trend Following Strategy

The most important aspect of technical analysis is perhaps the concept of a trend. Trend analysis is based on the observation that over the long-term price movements tend to persist, most often in an upward direction, thus generating gains (returns) for investors.

Trend analysis is especially relevant to crypto traders, since cryptocurrencies tend to exhibit significant and prolonged price movements. The fact that over the period of just three years (2015-2017), the price of  Bitcoin has appreciated by approximately 6,000% (from $315 to $19,500) implies that there has been a strong upward trend over that period. The ability to identify such trends on a timely basis leads to profitable trading.

As mentioned above, the most effective technical indicators of trends are moving averages and trendlines. Moving averages smooth out short-term price fluctuations, giving the trader a clearer image of a market trend. Trendlines and channels are alternative techniques for visual identification of upward and downward trends in price.

Mastering the application of these simple yet effective technical analysis tools by a trader is an integral component technical analysis and potentially a profitable trading strategy.

3. Follow the Net Position of Large Hedge Funds

As is well known, CME and CBOE – the world's largest futures exchanges – launched Bitcoin futures trading in December of 2017. This created a legal mechanism for a broad base of institutional investors and large traders to invest in cryptocurrencies.

What is particularly relevant to retail crypto traders is the ability to analyze the Traders in Financial Futures (TFF) reports, being published by CFTC to help the public understand the dynamics in futures market. The most valuable component of the TFF report is that it separates all traders into five categories, one of which is ‘Leveraged Hedge Funds’ and discloses the net position – either net long or net short – for each category of traders.

According to Preqin, an Alternative Data Database, hedge funds have been generating positive risk-adjusted returns over different time horizons. Thus, the trading strategy is straightforward: Open trades in the same direction as Leveraged Hedge Funds do, as evidenced by their net position. This potentially increases the likelihood to achieve profitability over the long-term.

For example, Exhibit 2 below presents the dynamics of Bitcoin Futures price (green line) and the net position of Leveraged Hedge Funds (red line). As seen below, the correlation is positive and strong: Since the beginning of 2017, while the Bitcoin price was declining sharply, the net position of hedge funds was net short and increasing in volume. 



4. Analyze Trade Volumes

Analysis of volume information is crucial. If volume increases during a period in which price is also increasing, that pattern is considered a strong positive signal. The signal would be interpreted to mean that over time, more and more traders are buying the cryptocurrency at higher and higher prices.

Conversely, if volume and price diverge, the implication is that the demand for the cryptocurrency is declining and the price rally will end soon.

Exhibit 3 below presents the trend in Bitcoin price and trade volume over the first half of 2018: Both the market price and trade volumes were declining over the period, indicating a strong bearish (sell) signal.





Another highly effective approach to volume analysis is Volume Profile. Essentially, Volume Profile makes the total volume traded at a specific price level during the specified time period visible. The indicator plots a histogram on the chart and reveals significant price levels based on the highest volume.

The ability to identify significant price levels is an integral component of a potentially profitable trading strategy, since it allows placing target take-profit and/or stop-loss orders at accurately defined price levels. Setting accurate take-profit and stop-loss levels is important from the perspective of profit maximization and risk management, respectively.

Conclusions

In this article, we have presented multiple trading strategies and their application to cryptocurrency trading. Overall, we concluded that a potentially basic profitable trading strategy for cryptocurrency markets represents an integrated approach to market analysis that incorporates fundamental, technical and sentiment factors as well as appropriate risk management tools.