A reader asked what my thoughts were on bitcoin and what kind of strategies I would recommend to trade this type of market.
I don’t want to get dragged into an opinion piece but I will say that there seem to be an incredible number of amateurs involved in bitcoin which could end badly.
As to what trading strategies might be useful for such a market, the obvious choice has to be trend following or just simple buy and hold.
What Kind Of Strategy To Trade Bitcoin?
I have found in the past that trend following strategies are better suited to new and inefficient markets.
This is because such markets tend to be less liquid and less driven by fundamentals. They can be more easily manipulated and are more prone to large speculative price swings.
Frontier markets, emerging markets, penny stocks and cryptocurrencies all fall under this category and they all exhibit volatile, extreme price action at times.
These markets also have larger transaction costs so trend following systems need to be low frequency enough to overcome these challenges.
On the flip side, I find that mean reversion strategies work much better for liquid, efficient markets like your traditional S&P 100 stocks and futures markets etc.
Another classic way to trade bitcoin is to use a simple buy and hold approach where you buy a little bit every now and then, building up a position in the market as you go.
This method would have obviously worked well with bitcoin over the last few years. You would not have had to invest too much in order to make big gains.
Of course, hindsight is a wonderful thing and equally, there is a real possibility of another 70-90% drawdown from current price levels.
Applying Trend Following Strategies To Bitcoin
As mentioned, trend following strategies are well suited to markets like bitcoin so long as they are capable of overcoming the large transaction costs that are typically involved with these products.
As it happens, our research program contains a number of simple trend following strategies that we can easily apply to bitcoin and therefore analyse the effectiveness of these strategies.
Simple MA Crossover Strategy
The first simple strategy we have is called Simple MA Crossover and this is part of our course Hedge Fund Trading Systems Part One.
This is just a very basic strategy that uses moving average crossovers to identify upward and downward trends. We simply go long at the beginning of an uptrend and then exit our trade when the trend changes.
Here is an example trade:
The long bitcoin trade was entered on the 13th October 2013 and closed on the 11th December 2013 for an incredible 583% profit.
Basic strategies like this are preferred for products like bitcoin because they are immature markets and we don’t have a large amount of history available.
The simple MA Crossover strategy was first designed for US S&P 1500 stocks. It is long only and the original system uses weekly timeframes.
Here we have applied the strategy to bitcoin on a daily timeframe and backtested it back to August 2010 with a starting capital of $5,000. We obtained bitcoin price data for free from Blockchain on Quandl.
As you can see from the equity curve and profit table above the strategy worked exceptionally well during the period and thanks to the compounding of returns our initial $5,000 has catapulted into over $300 million!
This works out at a compound annual return of 355.68%. This is actually less than the buy and hold return of 396.74%, however, we have achieved a smaller drawdown and therefore better risk-adjusted return of 617%.
Cherry Picking Trend Strategy
The next strategy is also a simple and classic trend following system which is available in the same course mentioned previously. The difference is that this strategy uses different parameters and is able to go either long or short depending on the trend.
Here is an example short trade from this strategy on bitcoin:
The short trade was entered on 31st January 2014 and closed on 26th May 2014 for a 25.5% profit.
Next we have again backtested the strategy on bitcoin daily data back to August 2010:
As you can see from the above equity curve and profit table we have once again produced exceptional results trading bitcoin and our initial $5,000 has turned into almost $50 million.
The annualised return in this example is 251.52% which is lower than the buy and hold return of 396.74%.
However, the advantage of using this strategy is that we have recorded a lower drawdown (68% vs 94% for buy and hold) and we have made money in every year. Whereas buy and hold would have lost money in 2014.
Of course, it should be noted that going short bitcoin is not easy and may have been even harder prior to 2017. We have also used commissions of 1% per trade which may be insufficient.
When I purchased bitcoin through the Coinbase broker in January I believe I was charged a fee of around 3%.
Trend following strategies work well for new and inefficient markets that exhibit speculative price trends. Whereas in more developed markets, mean reversion strategies tend to prevail.
Here we have tested two basic trend following models that were designed some time ago and they have shown to produce good results trading bitcoin.
We could easily have presented two different trend strategies here and shown much greater performance.
For example, I could have easily shown a strategy with a drawdown of under 20%. But that would simply be a lesson in curve fitting and you would have difficulty trusting those results.
Instead, we have presented two strategies that were initially designed for stocks and shown that they can also be applied to bitcoin. Thus, validating the strength of these systems.
Hindsight is a wonderful thing but these strategies would have worked well in the past and will continue to work in the future, if not on bitcoin then on some other trending market.
If you are interested in more useful trading strategies and research make sure to check out our program here.
Simulations and charts produced with Amibroker. Historical data from Quandl.