Cryptocurrencies was all the rave in 2017 and early 2018.
Let’s look at 3 trading strategies that we implemented and the market inefficiency behind those strategies.
1. Slow spread of news from China to the rest of the world (Information Asymmetry)
Market inefficiency we are targeting: Slow spread of news from China to the rest of the world.
In September 2017, China banned Initial Coin Offerings (ICOs) and imposed heavy restrictions on local cryptocurrency exchanges.
After the crypto ban in China was first leaked on China’s social media sites, crypto prices hardly moved.
We took a short position in Ethereum.
Hours later, the news spread to the rest of the world. Crypto prices crashed.
We covered our short position once we believe the news was priced in.
2. Prices differences between exchanges (Price Arbitrage)
Market inefficiency we are targeting: Prices differences.
Coin prices across different cryptocurrency exchanges do not always trade at the same prices. During the middle of 2017, crypto prices in Korean exchanges were 30% higher than non-Korean exchanges!
Naturally, we arbitrage such differences. Steps:
- We spotted 2 exchanges with different prices (not going to name the exchanges).
- We constantly bought the cheaper ether (ETH) using fiat currency (i.e. USD, EUR, JPY etc) at one exchange.
- Transferred the ETH to an exchange where ETH was trading at a 10% premium.
- Sold it for fiat currency.
- Moved the fiat currency back to the first exchange.
- Rinse and repeat.
There are many ways to implement such a strategy.
- Some don’t involve fiat currency – only crypto is involved.
- Some involve more than 2 crypto pairs.
- Some don’t require crypto or fiat movement. Buy the cheaper one, short the more expensive one. Wait for the prices to converge.
3. Loopholes in the way transactions/coin creation occurs (Market Microstructure)
Market inefficiency we are targeting: Loopholes in the way trading occurs.
Think of market microstructure as the underlying mechanisms that enable trading in the financial markets.
This part is slightly technical.
Cryptocurrencies can be created through forking. You can loosely think of forking as a process where you duplicate a coin. If we held coin A and it is forked, we now own coin A and the newly created coin B.
When Bitcoin Cash (BCH) was forked from Bitcoin in August 2017, we figured a way to long bitcoin on one exchange and be short on another exchange.
- Longing on Exchange A gave us (BCH).
- Shorting on Exchange B did not require us to give away (BCH).
The net result was that we are market-neutral (i.e. we are not taking any directional risks in the crypto markets), but got free BCH in the process.
At the end of the day, when you are trading (as opposed to hodling), you need to understand what is the market inefficiency you are targeting exactly.
Use that to manage your trade (when to buy, sell, double/half your position etc), not arbitrary price targets or gut feel.