Selling the Froth: A Hedged Forex Strategy and What, if Anything, It Tells Us

[DrGregMulhauser]

Although I wouldn't ordinarily launch into a discussion about trading strategies which are directly relevant to one of my own hedge funds, today I finished up an article called "Selling the Froth: A Simple Hedged Forex Strategy for Bitcoin-Denominated Returns", and I'd welcome any comments, criticisms, or alternative interpretations of what I've been seeing.

In a nutshell, on several occasions over a period of many months, it's been possible to lock in a reasonable level of return in BTC terms by buying additional bitcoins and shorting a corresponding number of Bitcoin vs. USD futures. Modelling over a range of exchange rate changes from -90% to +400% for the value of BTC, the strategy can still remain profitable -- sometimes even beyond a 400% gain in the value of the bitcoins purchased as part of the strategy.

What's puzzling to me is why such a strategy would remain profitable, given that it doesn't require taking a directional position, and given that it can be profitable even when plugging in quite a high cost of capital; i.e., why hasn't such an opportunity already been eliminated? In the article, I suggest at least two possibilities, including an inefficiency in the market or an aggregate market view of the futures exchange that is fairly negative, but as I say, I'd welcome comments, criticisms, or other interpretations.

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[DrGregMulhauser]

Just a quick follow-up for anyone who might be interested...

Today I published a one-month followup to the article I mentioned above, noting that the strategy has returned 14% during the last month.

[blankia]

Interesting read. You are obviously a very smart man.

I always thought that futures locked in the exchange rate, so how is it possible that this strategy loses in dollar terms?

[DrGregMulhauser]

...futures locked in the exchange rate, so how is it possible that this strategy loses in dollar terms?

The position is fully hedged, so the futures are balanced by a leveraged long position in Bitcoin. This is what enables the strategy to remain profitable in Bitcoin terms across such a wide range of changes in the exchange rate versus USD.

However, you're exactly right that futures lock in the rate, so a non-hedged position made entirely of futures would have done exactly that, as noted in this paragraph toward the end of the article:

Naturally, one might object that the strategy has lost money in fiat terms: a gain of 14% is not enough to offset a fall of 23%. However, the strategy was explicitly designed to create gains in Bitcoin terms, not in fiat terms, and to do so while remaining robust to significant changes in the exchange rate. Someone concerned primarily to avoid losses in fiat terms would simply have used the futures market alone to lock in a fiat price which was at a greater than 50% premium to the spot market, without regard for hedging against a gain in BTC versus fiat.

[blankia]

Ok thnx.

So what would be wrong with buying 1 bitcoin in the market (564 at that time) and selling a futures contract to sell at 865 (at that time). You would lock in a tremendous rate. Also no "risk". What would stop you? and why do you need a fund size 4 times as large as the amount of bitcoins deployed?

[DrGregMulhauser]

So what would be wrong with buying 1 bitcoin in the market (564 at that time) and selling a futures contract to sell at 865 (at that time). You would lock in a tremendous rate. Also no "risk". What would stop you?

Nothing would stop you from locking in this rate, and this would be a straightforward strategy for someone calculating their position's value specifically in fiat terms. For someone calculating their position's value in BTC terms, however, they might be concerned to avoid erosion in their BTC holdings should BTC rise significantly against fiat -- thus the strategy of coupling the futures position with an additional long position in BTC.

It all depends on aims and risk tolerance.

and why do you need a fund size 4 times as large as the amount of bitcoins deployed?

You don't. However, I was drawing the original article out of a bag of tools I had used in fund management, where it would rarely be appropriate to sink all of a fund's capital into a single strategy.

[blankia]

Thnx for your answers! Found it very interesting.  I myself would be interested in the Excel sheet, as I have slightly different numbers than you do and am not absolutely sure how you did calculate the numbers.

For the strategy that I mentioned, the rate of return would be 56% on a yearly basis if you plug in the numbers from today (not sure if I did it correctly). Is this high in the bitcoin world? What was the highest you have seen? There must be some very big pitfalls? I have come by one pitfal, as of yesterday you can not register anymore on that exchange :s. Not sure what kind of exchange wouldn't allow people to register, but it shows that there could be many more flaws in the sites design.

[DrGregMulhauser]

ICBIT just rolled out a major site redesign, so the trouble you experienced may have been related to that. As I speculated in the original article, however, a major source of risk for the strategy I outlined remains the exchange itself.

I'm afraid I don't have any other numbers to share with regard to highs or lows or averages, but I do think the going rates for futures are worth paying attention to every so often; sometimes the market is willing to be fairly accommodating.