To UnTether or Not to UnTether?

Last month, I wrote about the likelihood of the current cryptocurrency bear market growling to a halt...(https://www.dhirubhai.net/pulse/cryptocurrency-bear-market-ending-christopher-maydak/) At that time, the Bitcoin (BTC) and Ethereum (ETH) markets were pretty much in-line with long term market average trends. I suspected an imminent bounce was looming after the YE2017 spike had come back down to earth. My best guess was that a flatter consolidation period would soon follow, and that I would wait for a break-out before reinvesting more of my portfolio.

What followed was a brief break-out during mid-May, but we are now basically back to where we were six weeks ago. The BTC and ETH prices recovered a bit too much, and crossed the 75% price trend percentile, indicating an overbought position, and they have retreated back to the 50% trendline. I decided to dig deeper into this over-bought/over-sold indicator, and look at the historical probabilities of subsequent monthly yields which follow.

Tether (USDT) is a popular crypto coin which is used as a store of stable value without having to cash-out into fiat. It's price algorithm is constructed such that it is closely tied (or tethered) to the US Dollar. Thus, you can "sell" your crypto in a bear market by exchanging it for Tether in an exchange such as Binance or Bittrex if you want to later re-invest at more favorable conditions. (There are other concerns about Tether and similar "stablecoins", but I'm not going to get into that here. For the purposes of this article, I am focusing on whether or not to renter the crypto market. How you choose to do that is a separate discussion.)

What I did look at were the monthly price changes for BTC and ETH that follow the over-bought/over-sold indicator, and identified them binary as positive/negative. A negative future yield would indicate a good time to Tether in order to protect against losses, and vice-versa. The indicator is simply a measure of variance from the long-term trendline, where 50% means the current price is right on trend, close to 100% means the current price is deviating close to the maximum (overbought conditions), and close to 0% means the current price is deviating close to the minimum (oversold conditions).

The results speak for itself, where an indicator <65% (over sold or average conditions) results in about a 70% probability that the market is going to have a positive yield over the next 30 days. Once the indicator crosses 65%, this makes it more likely that the market is overbought, and will hence come back to earth. The higher the indicator, the more you should Tether to protect your gains.

So, we know a little more what to look for in terms of when to Tether or unTether, but how much? The precise answer depends on a few things, including comparing the actual gains to the losses and your individual risk tolerance level. Crypto is a hyper-risk asset, and I wouldn't suggest putting more than you are willing to lose. An ultra-risky portfolio might have as much as 20-25% of your overall investments in crypto when the market conditions are ideal, whereas a more conservative or novice investor is more likely to hold 5% in crypto assets. In addition, if you are on the riskier end of the spectrum, and invest in altcoins such as EOS, NEO, and Tron, this puts you in an even a higher/risk-reward category. Large-cap coins such as BTC and ETH are volatile enough compared to USD. The smaller altcoins tend to correlate with the BTC and ETH momentum, but at even larger swings. It's common for BTC to see a +/-2% daily change, whereas this can magnify to +/-10% on the altcoin scale.

However, if we look at the problem from a pure mathematical perspective, the Kelly Criterion does the trick to optimize our gains regardless of your individual risk tolerance. This is commonly used in investing and gambling, and more details are explained here... (https://www.investopedia.com/articles/trading/04/091504.asp)

The basic formula is Kelly % = W – [(1 – W) / R]

where: W = Winning probability, and R = Win/loss ratio

W is the percentage where you expect to break-even. In our case above, we are looking at the probability that our yield is positive, so our break-even ratio is 50%. You also have exchange fees to consider, so add that to W. Let's use 2% as our fees, so W=0.52. The R comes from looking at ratio of the positive to negative yields. (Note: This is different than P/(1-P), because the positives in crypto tend to be bigger than the negatives.) Tethering too much during a negative probability cycle can also miss on big break-outs, so we need to weigh the gains with the losses. In crypto, it's normally better to HODL (hold on for deal life) than sell. So, we are going to get slightly larger values for our R's when we take into account the magnitude of the changes. We can then slightly modify and rescale the Kelly formula to express our Tethering needs, by assuming worse-case we Tether everything, and best-case we Tether nothing.

Our best conditions are closer to a 15% indicator, so here we Tether nothing, and invest our max (as much as 25%). As the market reaches 85% overbought territory, we Tether half of our crypto-portfolio, and then steeply Tether-up from there.

So, where does this leave us right now? As of this writing, BTC and ETH are at $7,553 and $577, respectively. Their trendlines indicate they are slightly below the 50%-percentile price levels at a 45% oversold indicator. This means we should still have about 20% Tethered until a break-out starts, so the ultra-risky investor should be about 20% invested compared to a 25% maximum.

The "all-in" points would be if BTC were to drop as low as $5,600, and ETH to $427. Conversely, spikes up to $11,000 BTC and $840 ETH would result in a 50% Tethering position.

Read more: Money Management Using The Kelly Criterion https://www.investopedia.com/articles/trading/04/091504.asp#ixzz5H6hEY7x4 

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