Evaluating the downside risks of actively trading

On pure face value, active trading strategies that use trend following tend to outperform buy and hold strategies. When markets become overbought and roll over good traders leave, then when the market shows the beginnings of a rebound from oversold they buy back. While indicators and time frames may change, generally most active trading strategies follow this paradigm. 

While trend following has shown consistent alpha in traditional markets, the blockchain space has unique risks associated with actively trading which can shift the risk/reward profile towards buy and hold. These unique categories of risks when trading include:

  • Exchange risk - using a centralized exchange that can freeze access to your funds at any time while being vulnerable to attack. 
  • Hedging risk - using instruments such as USDT to hedge against downside risk with fiat currency. 
  • Fees - frequent trading incurs higher fees both from exchanges and the blockchain networks
  • Theft/loss risk - Each exposure of a private key or password to access funds creates the potential for a theft or loss event. 
  • Interest payment losses - most large holdings in our portfolio incentivize continued support of the network through interest payments which can only be collected inside of personal wallets.

Trend Following

Trend following can include any type of basic technical analysis such as moving average crossovers, relative strength index, Bollinger Bands, etc that show when markets are overbought or oversold. Active traders can make consistent and significant alpha over buy and hold strategies through disciplined trading plans that employ tight stop losses and conservative trade management strategies.

Even with such plans in place, market gyrations can "whipsaw" traders out of positions where buy and hold investors will capture the full extent of upward or downward price movement. Thus trend following strategies take considerably more time, effort, and skill, while also opening up the trader to the following downside risks unique to blockchain.

Exchange Risk

While some smaller decentralized exchanges exist, their lack of liquidity prevents them from being an attractive place to trade. Thus for the time being centralized exchanges offer the best place to actively trade. 

As evidenced with the BTC-e collapse and the continued pressure the Chinese government places on centralized exchanges, the most prudent course of action is to leave funds on exchanges for the least amount of time possible. However this incurs the additional cost in time and fees to not only place trades, but also place withdrawal orders back to personal wallets. 

Hedging Risk

When trend following, market data can signal to be out of blockchain tokens entirely and into fiat currency. The primary way traders hedge into fiat is with product called USDT. This is a blockchain token tied to the value of one US dollar. No major liquidity events have yet happened to test the USDT ability to pay users in US dollars, nor are the tax implications clear. 

Theft and Loss Risk

These risks cannot be over enough. Each time a transaction takes place there is the potential for the private keys and passwords to be captured by an adversary, or more commonly typing an erroneous sending address that will irreversibly send your funds to a non recoverable address.

Best practices can largely prevent these issues, but no transfer should ever be taken lightly. 

Interest Payments

Ending on a positive note, the mechanisms we look for in solid investment candidates also create additional returns through interest payments. These payments are generally only received in personal wallets, and not on exchanges.

True accretive returns can be tricky to calculate. While the additional number of tokens you own increases as payments are received, depending on your percent ownership in the network, and how many other accounts are also claiming interest payments, the dilution in the total tokens in supply can offset any interest payment gains. 

As an example NEM has only 9 billion tokens that will ever be created, thus each interest payment received from helping to validate transaction is 100% accretive. Eg your ownership share in the network increases. 

Conversely, in projects such as Ark, interest payments are shared by over 60% of the network thus the total supply grows roughly at pace with additional tokens received. This is further complicated as each project has a unique emissions schedule. For instance Ark reduces interest rate each year to encourage early adoption.

Final thoughts

The satisfaction of a well executed trade, and additional alpha from deploying a consistently winning strategy can make active trading worth the potential downside risks. 

Our fund has shifted into lower velocity investment strategies aligned more closely with the Berkshire Hathaway philosophy. Like Berkshire, we sit on a fairly large cash reserve as a percentage of investable assets. We then perform deep analysis to identify strong projects at attractive valuations, and view ourselves as long term owners of the project.

Knowing the potential downside risks mentioned above can help investors to make more informed decisions when choosing the trading strategies that work best with their level of risk tolerance.