Founder at www.protosmanagement.com. Senior portfolio manager and quant. PhD in Comp Neuro. SU Alumn
With the recent sell-off in global markets, we wanted to take the time to review the performance of our investment strategies in cryptocurrencies and evaluate the risk in them.
The graph here shows the performance of the cryptocurrency market since our first day of trading on 12/15/2017 until today (updated daily) as well as the performance of the different investment styles like momentum and small cap. We also show the performance of Bitcoin for comparison. Only momentum investing has made money since inception, while all other investment styles have lost money.
The idea behind investment styles is backed by solid academic research, aiming at above-average risk-adjusted returns and explaining market returns (see here for an introduction).
What did we learn from last two years of trading?
All returns above are calculated from a long only portfolio that is selected daily based on each investment style as explained here. We think there are the following important learnings:
1. Momentum has largely outperformed all other investment styles, because it participates in market rallies, but goes into cash during bear markets
2. Momentum is biased towards the small cap investment style due to the risk weighting of the index (it is more equal weighted than market cap weighted) as explained here
3. Small cap (altcoin overweight) has outperformed the market initially and then underperformed
Why was momentum trading so successful?
Since momentum has had such a phenomenal performance compared to the other investment styles, we want to dive in a bit deeper into the mechanics. Most importantly, momentum is considered to replicate a call option (for example see Hurst et al. 2013). The idea behind a call option is to let an investor only participate in an up-market and not in the down-market. Ideally the call option would only have upside, but no downside. Unfortunately, the call-option has to be bought for a fixed price, which is called the option premium.
At the moment, the call option for Bitcoin costs around 20% of the notional investment per quarter. That means, the investor will lose 80% of his investment over one year unless Bitcoin rallies and the call-option runs into the money. Momentum strategies became famous, because they were able to replicate call options for a lot less (see Hurst et al. 2013). We estimate that the cost to replicate the call option with a momentum strategy is about 10% per year, so in fact eight times cheaper than an outright call option (see below).
We have discussed this for cryptocurrencies in 2017 here, but wanted to review the results during our live trading. The headline figure shows the performance of the momentum investment style versus market returns over rolling 90 days. The figure also shows a fitted call option. As discussed above, trading long only momentum is replicating a call option. The figure shows that the return profile of momentum trading is very similar to a call option.
However, the investor in this strategy is not fully hedged when the market sells off. Especially if the market sells off up to 25%, the momentum strategy is still very much affected and only slightly reduces the risk to about 20%. However, the momentum strategy has worked well in larger sell-offs and reduced risk to about 10%. We calculated the average performance of the momentum strategy over 90 days, when the market performance was negative over the same period, to 2.66% and hence 10.66% over 1 year.
If the replication of a call option works well with the momentum investment style what about put options and even selling options?
Well, the same principles apply. Building a put option with momentum is essentially trading the short signals and has the pay-off profile as shown below. Of course, the put option has a higher premium as financial markets are risk averse and are generally protecting against the downside (see volatility smile for an introduction). If you now trade the momentum investment style long and short, then of course, we can replicate a so-called long straddle. The straddle is a simple combination of the call and put option and rewards the investor if the market is either rallying or selling off.
However, the investor has to pay both the call and put option premium, so the straddle is even more expensive. At Protos we only trade momentum long-only exactly because the put option replication is even more expensive and because we are optimistic about the general market.
What about selling options?
The pay-off profile for a short straddle is just the opposite of the long straddle, which is selling both a put and a call option. In this case, the investor is collecting the option premium. Therefore if the market moves sideways, the investor is generating a constant yield. However, if the market either goes up or down substantially, the investor is facing unlimited losses. That is why we think a lot of funds and investors that implement this strategy, have gone out of business.
If momentum investing is replicating a long straddle, then the opposite of momentum investing should be a short straddle. What is the opposite of momentum investing?
So consider the following market scenario: If the market has already dropped substantially, the momentum investor would go either into cash (long-only momentum investing replicating a call option) or go outright short in this market (long and short momentum investing replicating a straddle). The opposite strategy would of course be to buy this market and feel that the market is cheap and betting on a recovery. Of course if the market continues to fall, then this investor would face potentially unlimited losses. This strategy is called in general a mean-reversion strategy and is applied by market makers. As market makers are always quoting both sides, they are inherently facing the risk that the market continues in one direction and that they cannot close their positions. Another name of this strategy is buying-the-dip and it always has the risk of unlimited losses.
Which strategy is better — momentum or buy-the-dip?
Well that of course depends on the market and the risk appetite of the investor. The advantage of momentum investing is that the downside risk is pretty limited, but on the other hand loses small amounts of money over time if the market moves sideways.
The advantage of buy-the-dip is that this strategy generates usually a yield and increases the holdings slowly over time. On the other hand, this strategy is facing an unlimited loss, especially if the dip is bought multiple times with leverage. Since this strategy is applied by market makers, they usually have good performance for a period of time, but then get wiped out in an unexpected market crash like this one during March 2020 in both equity markets and crypto markets. In fact, we believe this is the reason why there are very large famous hedge funds and not many famous market makers — ultimately they just get wiped out once in a while. Or as the saying goes: “The trend is your friend”.
Protos Cryptocurrency Asset Management invests and trades established tokens like bitcoin using advanced quantitative strategies. It’s founders have 13 years combined experience investing in crypto, have managed funds/proprietary investments of over $1B, have founded and sold 3 tech startups for proceeds of 400M and 1 investment bank at a valuation of $250 million +.
(Disclaimer: The author is a co-Founder and CIO at ProtosFund)