There is a type of trading called spread, in which we look for instruments with high correlation thresholds, to take advantage of the small differences that appear between two (or more) underlyings over time.
The main strategy in this area is the spread between bonds. For example, the difference between the American 30-year future and the American 10-year future. They are two highly correlated products, but due to their different duration, they accumulate exploitable spreads in a systematic way.
These occupations encompass as much as 70% of total transactions that take place in the bond markets. Without going too much into the technical details of bond spreads, this article will look at a spread strategy applied to cryptocurrencies. The tests will be run on the best-known pair on which the deepest historical data is available: Bitcoin and Ethereum.
Rules for the strategy based on BTC-ETH spreads
Noting that Bitcoin and Ethereum are the two most important cryptocurrencies, and as such are correlated with each other, one can think of taking the spread trading route with these two instruments. Technically, the operation consists of simultaneously buy and sell the same monetary amount on BTC and ETH. When the strategy is long (buy) on BTC, it should be short (sell) on ETH at the same time, and vice versa.
This type of operation, which involves 100% of the time in the market to take opposing positions, makes it possible to be always sheltered from violent shocks in the cryptocurrency sector, such as the one that occurred at the beginning of 2022. With In this type of entry, the strategy will always be “covered”, or protected, by an opposite position in a highly correlated instrument. This means that even losses, at times when the strategy suffers, will always be limited. The same reasoning unfortunately also applies to earnings, which will be restricted by the “hedging” system.
The data that will be used starts in 2018 and lasts until July 2022. Time range on which the strategy will be executed is 1440 minuteswhich corresponds to 24 hoursor a trading day.
The strategy is based on the spread between BTC and ETH, and it is the spread that will provide the guidance on when to buy BTC and when to buy ETH instead.
Figure 1 shows the value of ETH in BTC prices: as can be seen, there is no clear and definite upward or downward trend, at least not in the last 4 years. Nevertheless, the value of ETH to BTC has increased over time at alternating times. In reality, there are periods when the spread is very volatile and nervous at times when it flattens.
So, to separate the “pumping” moments from the “emptying” moments of the propagation, a 40 day moving average will be used. When the spread crosses the average upwards, we will buy ETH and sell BTC. Therefore, when the spread crosses its average downwards, we will buy BTC and sell ETH. This way the strategy will always be at market with opposite positions.
Backtest of the “BTC-ETH Spread” strategy.
An example of the strategy’s trades can be seen in Figure 2, where it can be seen that they occur simultaneously. This is done to safeguard the basic idea of spread trading, that the position hedge should never expire, otherwise the main principle of the strategy will be lost.
Like all propagation strategies, this one also has involves both long and short trades.
Tests are carried out on point cryptocurrencies. A fixed monetary size is used for BTC and ETH, corresponding to $10,000 eachtaking prices from the world’s largest cryptocurrency exchange such as Binancewhich allows its position to evolve to more than 1/1000 of Bitcoin, which is equivalent to approximately $23 today.
Figures 3 to 5 show the results that this strategy produces.
We immediately notice that the profit curve rises (Figure 1). Importantly, the average trade (Figure 2) appears large enough to reimburse commission fees and overruns that, like it or not, one will face in live trading. The figure for the value of an average trade is around $170, or 1.7% of the value of the position taken.
When trading spreads, it’s good to remember that commissions and slippage have twice the impact of a traditional strategy. This happens because, in spread strategies, a single trade actually includes two distinct professions, a long and a short. Therefore, it is even more important to read the value on the average trade, because operating in the spreads is more expensive than operating conventionally.
The maximum drawdown of -$12,000 occurs after a very strong rally in strategy, which then saw most of those profits taken over. Apart from this rare episode, the strategy remains at drawdown levels proportional to the returns it provides.
Conclusions of the strategy
These first tests conducted on the spread between BTC and ETH can be considered satisfactory. It has been seen that the indications provided can also be exploited to some extent in live trading.
Moreover, what has emerged is that spread trading does indeed offer this much-vaunted protection. See the behavior of the equity line in the last phase of the backtest, where against the sharp declines seen in 2022 on both cryptocurrencies analyzed, the propagation strategy would have allowed a more peaceful sleep.
This was done, as noted at the beginning of the article, at the expense of profits, which would no doubt have been greater by simply buying and holding, but would probably have led to high stress in down times.
That’s it for this article, see you next time.