A Stroll Down Crypto Trading - Chapter 2

Beyond risk, two other foundational concepts in trading are diversification and capacity.

Behind both concepts, there are again many nuances on implementation with significant consequences in terms of portfolio performance. Let’s start by highlighting a few, without getting crypto-specific. Then we will get into why an asset class such as crypto is particularly challenging to correctly diversify, in a scalable manner.

Diversification is that idea that an investor would typically benefit from not concentrating their capital into too few positions. This diversification actually takes different forms depending on the investment objective:

• If you try to track an index, you could buy every single component of it in the right amount. However, this may cost a lot more than the index level suggests. Thus, you would try to buy as few components of it as possible, minimizing your cost and the tracking error to the index. This is constrained passive diversification.
• If you buy or sell assets based on directional views of where they should be priced, it likely is a prudent idea to have several views on several assets over a period relevant to your investment strategy. First, those views are not guaranteed to be right. Second, even if they are right, markets may not be able to absorb your entire capital on that one single asset both when you enter, and when you exit the position. This is unconstrained active diversification.
• If you buy or sell assets based on relative views of where they should be priced, or to isolate a specific factor affecting prices, then you need to buy and sell as few assets as possible to get you as close as possible to this specific factor you have a view on, in as cheap a way as possible. The view you have on this factor may not be correct, so it is likely prudent to have several views on several such factors over a period relevant to your investment strategy. This is constrained active diversification.

Capacity is that idea that an investor can deploy up to a certain amount of capital in a given strategy while maintaining its performance. It can be quite cumbersome to measure, and a half-art/half-science to account for when managing a whole fund:

• Capacity increases with the number, the market capitalization, and the liquidity of assets traded.
• Capacity generally increases as the assets are held longer.
• Capacity generally decreases with more leverage.
• The capacity of a group of strategies does not necessarily equal the sum of each strategy’s capacity. It could be much more, or much less.

Cryptocurrencies have some interesting characteristics that make it harder to smartly diversify, and to produce strategies with substantial capacity:

• Its market size is ~$2T, or 5% of the S&P500. However, 2 of its assets (BTC and ETH) represent 65% of the whole market, and 25 of its assets represent 90%+. To put this in perspective, it takes more than a 100 stocks to represent 65% of the S&P500 market.
• Most cryptocurrencies cannot be shorted.
• Most cryptocurrencies do not have derivatives (perps, options).

1.??? Simple Market Structure Analysis of Alts

I rely on data obtained through the public Binance API, stopping at the beginning of last year, for the largest 25 coins at the time (excluding stablecoins). Rankings have moved a bit since, with some coins dropping off the top 25 and others being added (e.g. Shiba Inu is now top 25, Vechain no longer is).

First, let’s examine whether Alts behave differently from BTC and ETH through the lens of correlation and risk. For the latter, we examine volatility over time (as a measure of general fluctuations) and typical as well as extreme drawdowns (as a measure of downside exposure).

• BTC and ETH make sense as ‘crypto market beta” due to their market capitalization relative to others. There is elevated diversification in the price action of main alternative tokens.
• Overall correlations tend to increase in bear market, and decrease in bull market, but this is a generalizing statement, as diversification remains pronounced throughout cycles.
• Subsets of these Altcoins appear to behave with elevated similarities for certain periods of time, likely reflecting crypto narratives affecting specific sub-sectors (e.g. Firstgen L1s, Layer-2s, Meme Coins).

Now for the risk side:

• Even from a risk standpoint, BTC and ETH are in a category of their own. They generally have much lower and much more stable risk.
• Altcoins level of risk can vary by multiples within short periods of time.
• Putting things in perspective, BTC and ETH have ~5x the risk of S&P stocks. Altcoins have more than 8x the risk of S&P stocks. For an investor with comparable abilities, it is 5x more capital efficient to produce a target nominal return in crypto. However, if one doesn’t really know what they are doing, they will lose their clients’ capital much quicker.

The subsequent chart looks at the relative magnitude of drawdowns on daily vs monthly horizons, as a way to ascertain how quickly losing streaks of moderate and severe magnitude happen, and therefore the extent to which one could do something about it a-posteriori to partially remediate.

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• When altcoins go through a period of moderate losses, they typically underperform BTC and ETH by 1 - 2 points, though could do as bad as -10 points. The blue bars show us that those losses slowly spread over the course of a couple of weeks, therefore being very manageable.
• The orange bars show us that when alts really have a bad time, then those losses tend to be very quick and there is not much that can be done to mitigate after the first really bad day. In such situations, altcoins typically underperform BTC and ETH by 2 – 5 points, though could do as bad as -20 points.

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2.??? Altcoins Risk/Reward Analysis

Let’s spare our eyes going through two dozen charts of performance breakdown for each coin across Strong / Moderate / Range Bound Bear and Bull regimes.

Instead, let’s contrast BTC, ETH and Altcoins in terms of the intensity with which they switch between Bear and Bull regimes.

While a few Altcoins have a much higher propensity to rapidly jump across regimes, the more relevant observation is that most of them stand-out because of the sheer size of price moves that happen when those rapid regime jumps occur.

Those massive swings require to actively manage positions in these tokens, and being very mindful of trading execution.

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3.??? Dynamic Portfolio Management: Where Does That Leave Us?

Back to the topic that started this part 2: diversification and scalability.

Diversification in crypto turns out to be quite good. Not yet at the level of what stock traders are accustomed to, but quite in line with what FICC traders deal with.

• Broad crypto market views are best expressed through BTC and ETH, whether spot, perps or options.
• Altcoins lend themselves well to event-driven strategies, as well as fundamentals or technicals-driven longs (until we get better perps and options coverage) that are likely to be more tactical in nature. Proactively taking profits is critical, as many will go through rapid steep swings.
• Factor-specific views need to be carefully constructed, generally requiring using a mix of spot and derivative instruments. Managing leverage, risk and cost on such factor portfolios is of paramount importance.

Scalability can obviously improve and will do so naturally as the asset class matures. The best way to proxy top-down for what is feasible in cryptocurrency active management is to rely on metrics from the broader hedge-fund industry

• The top 100 hedge funds manage ~$1.35T of AUM, so the best hedge-funds on average grow to $13B in AUM with a median of $6B.
• The dominant strategies are macro, asset selection, and event-driven
• Those funds tend to deliver 15% annual return on 15% annual volatility (quant funds target much less volatility, in exchange for much more gross notional leverage).
• Crypto is on average at least 5x more volatile than traditional assets. Assuming investors of similar skill level in crypto (which between my analysis above and knowledge of the sector, I can tell you is true), and mindful of the market capitalization concentration in crypto:

It is realistic for a crypto hedge-fund to scale to $1-2B of AUM delivering annual net returns of 35%+.