I did a study on Bitcoin and was looking for a way to reduce price risk, yet still fully participate in the lucrative gains that Bitcoin has seen in the past. I essentially wanted to take the guess work out when to be invested and when to take profits, all considering that I am a long term believer of blockchain and my desire to participate in this trend.
Benchmark performance: HODLing (Buy-n-Hold) Bitcoin
I chose to look at two years of data from 01.01.2016 to 31.12.2017 from Bitfinex. I ignored commissions and slippage in this analysis and bought 1 bitcoin when the price was about 425 USD.
So HODLing (buy-n-hold) bitcoin would have produced stellar gains of over 648% annually in those two years. However, the drawdown would have been 9173 USD of your portfolio value. Not many people can easily stomach giving back almost half of their gains and people who have been in the cryptospace long enough, know that there have been times with much larger losses.
But what if there is a way of reducing those large losses yet still being able to participate in the upside gains?
I created a simple strategy (I am a fan of simplicity especially in Algorithmic Trading) that uses the following rules:
Buy BTC when it trades (1 Tick) above the 10 day High.
Sell BTC (close long trade and be flat) when it trades (1Tick) below the 5 day Low.
That’s it. No other rules. Lets look at the performance:
What we can see is that the return is slightly higher with 11980 USD gained but the drawdown of 4412$ is cut in half, a major improvement.
The input parameters for entering (10 day high) and exiting (5day low) the bitcoin position were randomly chosen. Lets check if those parameters can be improved. I tested in 5 day increments (so entering on a 5 day high, 10 day high, 15 day high etc.):
Looking at the test results from above one can see that entering at a 10 day high and exiting when bitcoin trades below a 5 day low is not ideal as more profits can be generated if one enters and exits at a 10 day high/low. However this is where it gets tricky. My original idea was to enter when bitcoin makes a new 10-day high and get out of the position when it trades below the 5 day low. Switching now to a new rule set of 10/10 becasue of a backtest could lead to overoptimization (also known as curve fitting, overfitting) and in systematic trading you want to avoid overfitting like the plague. I will describe the challenges of curve fitting and ways to deal with it in another article in the future.
So we have to be careful not to curvefit the model, yet there are a few things I like about the other parameters. The main benefit I see would be a reduction in trades. This is a longer term investing/trading strategy for bitcoin and I dont want to be too active as it increases trading costs (commission and slippage) and would require having the bitcoins more often at the trading Exchange instead of a cold storage like a Trezor, Ledger or paperwallet. And Bitcoin or Altcoins should always be stored in a cold storage wallet if possible. For the sake of this analysis I will leave the trading methodology as is (enter on 10 day high, exit on 5 day low). Since the CME & CBOT offer Bitcoin futures we can actually leave the bitcoins in cold storage and hedge the risks via futures.
I will describe how this works in a future arcticle. If you want to use this trading model but with parameters where you dont have to trade that frequently I would use parameters like 10 (exitlevel) & 20 (entry level) so one would have very similar results (over 12000$ profit with 4954$ of drawdown) but with a lot less trades.
Lets add more data and see if the original method still outperforms HODLing Bitcoin.
I added data from November 2013 until today the 25th of February 2018.
The benchmark again is HODLing where one buys 1 BTC on the 16th of November 2013 (thats the first day of somewhat clean data from Bitfinex) for 420$ and holds it until yesterday (24.02.2018).
So buy and hold Bitcoin from November 2013 until today yielded 9723 $ with a hefty drawdown of 13891$.
The simple Bitcoin trading strategy where you buy when Bitcoin makes a new 10 day high and sell when it breaks below the 5 day low significantly outperformed HODLing on an absolute and especially on a risk adjusted basis as can be seen below:
The periods from 2013 to 2016 and 2018 can be seen as a so-called out-of-sample test where we used the same parameters as before but on “unknown” data.
Below is a screenshot of the most recent trades and as of 25.02.2018 the trading model (5 & 10) is out of the market:
Lets also peak at the other entry/exit parameters over the whole period from November 2013 until today (February 2018) and how they would have performed:
From the 25 possible parameter settings, 22 of them outperform buy and hold on a risk adjusted basis.
The 10 & 20 model mentioned earlier also significantly outperformed the benchmark.
While HODLing is viable approach to investing in Bitcoin, using some form of exit methodology might be easier to handle psychologically as drawdowns can be reduced and even profits could be increased. Although this method seems to be robust (it has only 1 entry and exit rule and performed well on an out-of-sample basis) there cannot be any guarantees that this will still be the case in the future. The model will actually lose (underperform) when bitcoin trades sidewards constantly as multiple stop outs could occur.
What makes me believe that this model will keep performing well is the fact that Bitcoin experiences extremely strong price moves, something I dont expect to change dramatically in the near future. I like the simplicity of the trading model and if one does not have a futures trading account to hedge risk (i.e. go short futures when an exit signal appears while keep holding the “spot” bitcoins in a paperwallet) then he/she could look at using 10/20 parameter setting (exit at 10 day low, enter at 20 day high). One thing seems likely, if Bitcoin really does reach heights of 50’000$-100’000$ or higher in the next few years then this model should keep doing well. Until then, best of luck.
***Trading Futures-, Options-, Equities and retail off-exchange foreign currency or crypto currency transactions involves substantial risk of loss and is not suitable for all investors.You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time and should not be construed as an offer or a recommendation to buy or sell a security nor is it to be construed as investment advice.