Trading and Cryptocurrency Creative Destruction
Today’s “Long Story Short” discusses different market properties to consider when trading cryptocurrency. Kollider’s series is purely educational and not investment advice. Please do your own research.
As the cryptosphere forges ahead with a seemingly boundless amount of novel technology and applications, it’s clear that we are currently in the creative phase of a structural “creative destruction”. The result is a variety of different tokens, coins, protocols, and trading venues that seem endless and even confusing. However, there is one thing a trader should remember: creative destruction produces opportunity.
In fact, that opportunity is necessary. There is a reason why the everyday crypto enthusiast often hears the terms “liquidity” and “market making”, although they are not traders. It’s because both the creative and destructive phases of innovation can have very sharp, jagged paths, and traders help smooth out the process. The middle people, as we sometimes think of them, are also vital. This is because they typically take a healthy chunk of the early risks inherent to new tech as it paves its uncharted journey towards either future boom or doom.
Market Characteristics to Consider
This “creative destruction” creates fragmentation. There are so many cryptocurrency exchanges in the ecosystem now that a novice may get analysis paralysis on where to start and how to trade. So, today, we’ll give you some pointers on what to look at to give you that initial dose of encouragement.
We’ll go over quite a few of the base level properties of a crypto exchange that you should look at and run them through a few common strategies. Keep in mind that we are largely talking about trading on an exchange with an L2 order book like FTX, Coinbase Pro, or Kollider Pro. And though some lessons could be applied, these are less relevant to paradigms like automated market maker exchanges. At the simplest level, we can start with the following to discuss how they may affect a strategy.
- Bid-Ask Spread
- Fee structures like rebates and progressive paradigms
- Funding mechanism
Each of these bullet points could certainly be an entire article on their own, so for now we’ll go over just some strategies and how the attributes above come into play.
Applying Them to Market Making
Let’s consider the market making strategy as we have described before. This version uses a single exchange, moving bids and asks to keep up with changes in the reference price or leans for that venue.
This strategy performs best when its bids and asks are immediately traded. The maker is at risk if a side, say bid, is filled. Getting a fill on the other side, an ask in this case, as quickly as possible lets the maker lock in a profit immediately. Traders often call this a “turn”. Profitable strategies do more and bigger turns.
These might hint at a couple of market characteristics that are important, the bid-ask spread and the volume. The wider the market’s bid-ask spread, the easier it is to be in front of the market. Thus, we could more easily get filled whenever someone wants to take that side. In addition, the higher the volume and the more two-sided, the faster we’ll get the turns and the greater chance that we’ll fill both sides faster without adding risk to the maker.
Tangentially, we could look at the fee structure. For a maker, it’s ideal to have low maker fees. The lower the fees, especially if we get rebates, the tighter our strategy’s ask and bid prices can be and still be profitable. As our spreads get tighter, we usually get more volume and so our turn performance improves. While the profit per “turn” stays the same, the sheer volume is higher.
The ideal situation of wide spreads, large volumes, and incentive fees does not always and maybe even rarely exists. So, we may want to start looking at other market attributes. As a maker, liquidity has an effect similar to the bid-ask spread. Since a maker is trying to compete with other passive orders to get the flow of trades coming through, the lower the liquidity with the rest of the product’s properties held constant, the better it is for the maker. They will likely get quicker “turns”.
We could also explore the effects of mean reversion and volatility. If market spreads are tight and liquidity is dense, higher volatility means we are more likely to get at least one side of our orders filled at a given point. We can still make markets if we find the right pricing mode;, but by itself this may not be helpful, as the market may only fill us at undesirable prices (perhaps adverse selection).
We still can make markets even if the spread, liquidity, or volume aren’t ideal. But it just means that markets become very competitive to make. There are different ways to solve this, and some of these become the “secret sauce” of each trader or firm.
Onto Discretionary Trading
While you can theoretically work with any strategy and perform well, once making gets too challenging, you might start to consider alternative frameworks. For example, we could look at a directional taker strategy. Sometimes called discretionary trading, this almost has the opposite ideal situation for a market maker.
Tighter spreads help taker strategies since they can have tighter pricing both on entry and exit. Higher volume could potentially help insofar as creating more volatility. However, more volume may also mean more competition for pricing. You can only get so many orders at a certain price, so if someone beats your strategy to get that price, whether by execution, by smarts, or just by chance, you have the option of not taking a position or taking a worse price.
Volatility is good for this taker strategy as well as for a maker, but ideally, wild price changes tend to trend one way versus quickly mean reverting. However, if the trend has a more predictable mean reverting pattern, we may still be able to predict future moves better, which is always a good thing. Ultimately, the discretionary strategy wants to have ease of getting the prices it wants and to be able to predict when it’s turning so that it could correctly follow the market.
Spread Trading and Moving Forward
We can branch to other trading approaches if we add the market maker to the spread trade. It can be broken up into a shorter time horizon vs. longer term spread trading, for example.
We gave a breakdown in our previous spread trade article on how this works. Like the other strategies above, we can still consider similar things that the directional taker or maker above had to look at, depending on whether we make or take on an exchange (remember that there are two markets now). Of course, we would also have to analyse the properties of the spread price itself, but this could still be done similarly (e.g., what is the volatility and mean-reversion of the spread prices?).
If we want longer holding times for our spread trade, we have to consider yet another variable that becomes a lot more relevant, the funding rates and their mechanisms. Funding itself can affect P&L even if our positions don’t change, and we’re delta neutral. This is particularly true for perpetual swaps.
Given how varied the topic is from exchange to exchange, we won’t discuss the funding too much here, but we can provide an example. In some exchanges, Kollider included, the funding is paid to the position holder when the derivative is short. (This is not always true, so you have to perform the analysis).
We could cover plenty more strategies, sub-strategies, attributes, and second-level attributes, but these should help get you started. As the ecosystem matures and consolidates, the creative destruction and relatively easier trading opportunities won’t last forever.
For now, inspect different markets and analyse their simplest properties, and then take your first step.
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