Using Algorithms to Limit Loss in a Market Crash

Whether you're a retail or institutional investor, a traditional or alternative investor, you probably just lost a lot of money.

After all, around $11.5 trillion was wiped from US stock markets, so it'd be impressive if you didn't. Cryptocurrencies from Bitcoin to Ether didn't make it out either.

That being said, many investors did make it out, and there's a way you too can limit your losses in the event of future of Black Swans.

Here's how.

Dynamic Cash Hedging

In the long term, we know that cash is a really bad investment. Not only does cash fail to bring positive returns, but it decreases in value due to inflation.

However, the picture changes in the short term, where cash is a remarkably stable asset. Cash is the backbone of the economy, and while it's up for debate whether an asset like gold is a true "safe-haven," there's no questioning that cash is a safe place to park your money.

Therefore, cash can act as a useful part of your portfolio. To decrease risk, you can reallocate assets to cash. If you have a higher risk appetite, you can invest more of your cash into other assets. Along the same vein, if your portfolio is crashing, you can "hedge" your investment by re-allocating assets to cash.

While almost $12 trillion was wiped from US investors' stock portfolios, the value of cash remained the same. $1.00 was $1.00 before and after the crash.

How Does It Work?

An investment fund that does dynamic cash hedging for you is Invictus Capital’s CRYPTO10 Hedged fund. As described in their litepaper, the fund offers a “dynamic asset allocation strategy that dampens volatility and provides protection against losses.”

This algorithmically fueled fund performed far better than its non-hedged alternative, CRYPTO20, during the market crash.

Since algorithms are fueled by data, the natural question to ask is: Where does the data come from?

As written in the litepaper, this fund indexes the “top 10 cryptoassets.” We can easily find publicly data on cryptoassets from CoinMarketCap.

The paper goes into the high-level mechanics on how their algorithms work, although it can't give the secret sauce away completely.

CRYPTO10 Hedged includes weekly rebalancing as well as a dynamic asset allocation framework, allocating between a “cryptoasset index base strategy and a cash position based on a variety of fixed parameters.”

While the full paper is deeply technical, CEO Daniel Schwartzkopff gives a simpler explanation:

“Transparency and the scientific method are core tenets of our philosophy at Invictus. We believe that all funds should be developed and justified with a data-backed approach. We do not rely on guesswork and intuition.”

Parameters of the aforementioned base strategy include a rebalancing period, and the number of assets. We have insights into the data given as input, the algorithm's strategy, and the parameters. We even get to see the basics of the fitness function used:

In the above, ai is a weight, and Xi is a performance criterion. Maximizing this function creates a portfolio close to the “efficient frontier” - or in other words, making the most money at the lowest risk.

Ultimately, given the recent performance of CRYPTO10 Hedged, algorithmically-powered dynamic cash hedging can be a very useful tactic to limit your losses.

Disclosure: The author is a consultant at Invictus Capital.