Bitcoin and the general concept of crypto currencies are one of the hottest topics in finance right now. The battle surrounding this subject is fierce and ideological, involves powerful forces and is far from over. But with Bitcoins price likely to continue its rollercoaster ride, there is no need for traders to have a personal opinion in either direction to profit from one of the world’s most volatile underlyings.
» Different opinions and visions make prices move and the unclearer the future the more volatile the price. One of the most controversial debates over the past twelve months or so has been Bitcoin and the potential of its underlying technology. While many people believe that so-called crypto currencies represent the future of not only money but also economic transactions in general, others are more skeptical and perceive it as a scam or a shady tool to finance illegal activities.
This wide range of opinions is one of the reasons why Bitcoin is moving the way it is, with regular price swings that leave most penny stocks in the dust. With developers, entrepreneurs, banks, regulators and central banks trying to get a grip on this subject, the future continues to be wide open.
Thankfully, we as traders don’t have to have an opinion; if anything, it is actually a disadvantage to have one as it can cloud your judgment and make you ignore or overlook patterns that contradict your opinion. So let’s concentrate on the aspects that make Bitcoin such a special trading vehicle and find a way to profit from it.
The Pros and Cons
First of all there is Bitcoins relatively limited trading volume and market capitalisation. With only a few hundred thousand units being traded over several different exchanges per day and a market value of just around $5 billion, there is not a lot of space for institutional sized participants to play this market.
Hedge Funds and HFT (High Frequency Trading)- Outfits being limited to arbitrage strategies is great news for individual traders because trading opportunities or edges usually tend to disappear once Wall Street’s best brains and billions of firepower get involved, especially in rule based, algorithmic trading.
Another positive fact is that Bitcoin is the only underlying that is truly traded worldwide at any given moment. Stocks can jump around a lot overnight, and even super liquid currencies canbe subjecttohuge weekendgaps; theoretically Bitcoin will never have this problem as market moving news can be priced in immediately, 365 days per year.
However, an immature market and the absence of institutional liquidity creates many difficulties too, and those have to be addressed in order to trade this market profitable. Due to it being a young, unregulated and decentralised market, there is a variety of competing exchanges that post individual bids and asks and trade very different volumes of Bitcoin per day.
As quotes and transaction costs are very important variables to any trading strategy, it is recommended
to first find an efficient venue to trade on and then use that venues data as inputs to determine the suitability of your strategy. Depending on your country of residence, you will have a few options to either sign up with one of the major Bitcoin exchanges or go through one of the increasing number of Forex brokers that offer CFDs on the Bitcoin price. Exchanges often offer lower transaction costs but sometimes lack a convenient way of using leverage and shorting.
It is alsocrucialtokeepaneye onthe grade ofownership one enters when going long Bitcoin. If your coins will be stored in a so called hot wallet they could easily be stolen in a hack attack, which is exactly what led to the demise of the largest Bitcoin exchange Mt. Gox last spring. Many exchanges now claim to store the majority of funds in cold wallets on servers separate from the operations front end and should therefore be impossible to breach.
To completely sidestep this problematic, one could choose to only trade Bitcoin via CFDs that are based on the price movement and never imply any direct ownership. But this seems to be the more expensive way to trade Bitcoin as some CFD shops charge a fix numerical fee of up to 6$ per Bitcoin and transaction, which charged on a 300$ vehicle would kill any strategy.
Another big factor to watch is the slippage experienced when trading, which is usually more extreme in illiquid, low volume markets. The strategy introduced in this article will use stop orders at important resistance and support levels to enter and exit trades, which makes slippage an even bigger danger.
It is, on the other hand very crucial to follow every signal in trend following strategies as a few good trades can make or break a year. So as long as we keep it in check we will have to accept slippage as price moving dynamically in our desired direction.
The author’s broker of choice acts as a liquidity provider for a couple of exchanges. Participation happens via CFDs so there is no risk of losing the actual coins. A fix
0.5 per cent transaction fee per roundturn is charged with no additional costs for borrowing to short or financing margin trades.
Average slippage over the past 20 trades or so has been at 0.15 per cent per roundturn, but we will assume
0.25 per cent to rather be on the safe side. These costs will be used as inputs to validate our strategy and backtests were performed on the same broker’s historical data.
What Approach to Take?
The type of strategy you will choose depends on the pattern you identified and in our case, there are not a lot of choices. We are dealing with a highly volatile instrument that has no problems ten-folding in two months or being cut in half in a day, which immediately eliminates mean-reversion type of strategies and points to the trend following approach.
Strategies in this area often use moving averages (MA) as directional filters or entry signals. Depending on period, this makes only limited sense with Bitcoin as those indicators are lagging and might not detect a trend early enough. For those reasons, one should favour a channel breakout strategy, easily applicable with stop buy and stop sell orders.
The period of time that defines our channel should be kept rather short to create signals that are more reactive. The author has used 3-day highs and lows in a lot of variations before, which seems like a fair starting point. To make the system less static we will transfer this rule into a faster timeframe by applying a 18-period MA on a 4-hour chart, for a rolling channel defined by the last three days absolute high and low. Figure 1 shows that channel and the signals it generated over the past three months.
A single rule that simple is not likely to work perfectly all the time and a quick look on the results confirms that. While this 3-day channel works well most of the time, it really struggled throughout the bubble moves that Bitcoin experienced around the end of 2013.
With volatility being a chance and a risk at the same time, it only makes sense to put volatility into a comparable perspective. To achieve this we will put a slight spin on the traditional Average True Range indicator (ATR) and calculate it off per cent values instead of absolute ones.
So with a close of $300 and a range of $6, our ATR will be two per cent instead of $6 so that we have a more accurate expression of range of a volatile price. This read will store volatility in a better way than comparing an absolute value to the most recent close. Averaging those numbers over a period of 86 will give us a pretty good indication of the last two weeks volatility, and over the course of the last year this average fluctuated between 0.8 and 8.
With ranges that different it becomes obvious that we will have to adjust our parameters at times, and after reviewing our per cent ATR, we can say that spikes over a value of 4.0 only happen in particular unsettled times. We will use this threshold to tune our strategy more sensitive to short-term trends. Whenever our per cent ATR is above 4.0 we will shrink our channel period down to four 4-hour candles in order to catch fast moving trends in highly volatile environments. Figure 2 shows our systems final long/short periods directly on the Bitcoin price and the corresponding per cent ATR.
But even with periods as short as 16 hours, our channel highs and lows can still at times be 50 or more per cent apart from each other. Using only the reverse signal as an exit rule would be extremely dangerous which is why we will apply a simple ten per cent fix stop- loss (SL) on entry, safeguarding our capital in the worst case scenario.
Results and Considerations
This simple set of rules achieved a total return of +917.6 per cent after commission and slippage over a period of 375 days from November 2013 to November 2014. The deepest drawdown accounted to -44.8 per cent, which was recovered within 20 days. Five out of 89 trades ended with our worst case SL of -10 per cent being tripped while 20 of 89 returned over ten per cent.
The winning rate of about 44 per cent is sufficient because the huge difference in average wins (11.7 per cent) versus average losses (-4.2 per cent) makes this method highly profitable.
The parameters used here were chosen rather intuitive and are not optimised, but even after trying a couple of different values (ATR period 50, lower or higher thresholds between slow and fast environments and different channel periods), the general tendency of the strategy remains very positive. Considering the total return and maximum drawdown, one should actually trade this strategy with only half the
committed capital to keep temporary losses in a more acceptable range (see Figure 3).
Before jumping head first into the Bitcoin experience, please consider all the pros and cons of trading this market. Find a venue or institution that you can get comfortable with, consider all expenses and safety issues that you might encounter. Do your own research on trading volumes, slippage etc. and then backtest whichever strategy you want to pursue with that institution data. The rules outlined here should be seen as an inspiration or a base to make your own research off and not a complete and secure trading system.
Even while trading, pay close attention to slippage and changes in the nature of how Bitcoin trades; after all this is a very immature market and one year of reliable patterns does not guarantee anything for the future.
And last but not least, keep the capital allocated to any Bitcoin strategy within your own pain limits because after all, trading crypto currencies is still more of an experiment than a safe investment. But with all those precautions in place, one should be well prepared to profit off Bitcoins wild swings, without having to pick a side in the heated debate over the future of money. «