Crypto Trading Antifragility — Part1 — Risk
When there is blood on the streets, both in traditional and crypto markets, enthusiasts panic and lose their precious coins. Some wonder “if Bitcoin is a good store of value, how come it crashes down along with everything else?”
While bloody markets rage on, a small number of traders are still making profits with the right approach.
For the prepared, volatility is a friend, for the unprepared it’s a nightmare.
First of all let’s be clear about BTC:
- 1BTC = 1BTC
- The fundamentals of the network remain
- It cannot be printed into oblivion
- It is border-less
- Open
- Neutral
- Global
- Censorship Resistant...
With that in mind I want to cover the basics of antifragility and convexity for crypto traders, as these are the best ways to get disproportional benefits on any kind of market, especially on difficult ones. These posts are meant to be conversational and all feedback is welcomed, so please leave your opinions and questions in the comments below.
Market success is a matter of finding the methodology that is right for you—and it will be different for everyone—not a matter of finding the one true methodology.
― Jack D. Schwager
Know Thy Risk
In order to the use good strategies, we have to understand our risks very well; see them as they are, not as we imagine them to be. Also, we need to be very clear on how to deal with them. Once our understanding is crystal clear the right action comes with easy.
Risks vary in scope and severity.
Severity
From mildly annoying to a catastrophic problem
Example for traders:
Mildly annoying – a minor loss on a stop trigger.
Catastrophic – you lost everything and even owe more than you currently have (this can happen with naked option selling on regular markets).
Scope
From small to large scale, or individual to the global
Examples:
Individual – One person lost confidence in crypto
Global – Everyone, including crypto enthusiasts lost confidence in crypto
3D Risk
Severity and scope offer a broad perspective, but for now let’s focus on the forms of risk, think of them as dimensions. Mostly outside our control, we cannot control the events underlying major risks, we can only control how we are exposed to them, and this is enough.
*Note - you can add more risk dimensions to your threat model, these are just the most relevant and common in crypto.
Systemic Risk
Examples:
P vs NP is mathematically proven to be equal and all modern cryptography is flawed.
A new whistle-blower provides documents showing those beloved 3 letter agencies have used hardware exploits to compromise every crypto.
Market/Price Risk
BTC drop on 2020-03-12, how many stop triggers were skipped that day?
ETH DAO “hack”
MTGox Fraud and collapse
Usability Risk
A user who doesn’t understand crypto losses his coins due to ignorance and poor management of his wallet (any resemblance with a famous economist recently is coincidence).
You get the idea.
So, how do we deal with those risks? In essence with a single strategy and slight adaptations:
Systemic risk is the largest in scope and severity, while being the least likely to happen. But we need to be prepared regardless. So the constant theme for dealing with risks is this:
How does a bad (or good) event affect you?
If the worst thing that can happen to you is closer to “mildly annoying”, on your severity scale, then you are on the right track. Of course some things can never be that insignificant, but it’s a good benchmark to have.
Having almost 100% of your portfolio on BTC will expose you to too much systemic risk, however unlikely these events are, they should always be on your mind. To reduce the severity you have to reduce your exposure, or find different revenue streams. This results in more options, which is another essential aspect of antifragility.
Market Risk is more worrying for those who desire price stability relative to fiat currency, but even die-hard crypto-heads worry about it when there is a price crash. The foundation here is the same of systemic risk – control exposure and have optionality, the possibility to choose without having the obligations to do so.
Usability Risk requires a different approach because you have already controlled your exposure, which is at a lower level so to speak, now you just need to think about securing what you have.
In it’s simple form: where do you generate your private key, and how do you store it? Here you need to find your best balance between security and convenience. This is different for everyone. In general I would recommend a large capital percentage with high security which also means low convenience (offline keys), a smaller percentage medium security/medium convenience such as a hot wallet on a pc (my preference is for GNU/Linux operating system), and an even smaller amount on exchanges which presents the highest risk because the private key is not yours.
*Note - I don’t trust hardware wallets – how can you know for sure there is no security flaw at the hardware level? Practically impossible, but that’s for another post. Smartphone wallets are another rabbit whole; if you really need them keep the amounts small.
Not having the private key is generally a bad idea, unless you have a low exposure to its negative results and a high exposure to positive results: we’ll cover more about this on part 2.
Is the idea of controlling exposure burned into your synapses by now?
I hope so, because it’s the essence of the barbell strategy.
The Barbell Strategy
The name is a reference to a gym bar with weights at both ends and nothing in the middle. Unlike the lifters use, it is asymmetrical for us. The classic example is 90% of your portfolio on the ultra conservative and just 10% on high risk. The proportion can be changed according to personal preference, as long as the safe side is able to stand the risk of ruin of the opposite.
You are operating with two opposite modes at the same time: one ultra-conservative, the other highly volatile. This is how the risk of ruin is avoided, although it can never be completely eliminated!
It can also be applied in a fractal manner, e.g. within the risky area allocate 10% of that to borderline stupid ideas with high chance of failure, but a huge potential payoff.
Forget about average risk, or trying to get the best risk/return using some kind of crypto-index fund; being in the middle can never bring high returns, and it is open to catastrophic failures. When you operate at both extremes those risks high in severity and scope are capped, while the benefits of volatility keep working in your favour because small mistakes don’t cause much harm.
And like the previous example of using different revenue streams to manage systemic risk on crypto, it can be used on distinct areas of life.
Antifragility and convexity for traders - overview
Antifragility is a mathematical property of complex systems, where there are several parts interacting with each other in a nondeterministic and nonlinear manner. Small parts can fail to disorder such as stress or volatility, this is how feedback is generated to the larger system, resulting in improvement over time. Just like muscle cells damaged after the stress of a workout lead to stronger muscles, these concepts can be applied to trading by leveraging small failures and avoiding ruin in the larger portfolio.
When the negative side is limited to the small, then the positive side can be unlimited, in theory at least, still very high in practice regardless.
Anyone who has to avoid failures or rely on a specific path, has strong signs of fragility – that which was once broken doesn’t return to its previous shape. This is why it’s necessary to avoid ruin before thinking about making profits. While personal financial ruin is not necessarily absolute or final, after all it is possible to recover later, it does steal away precious time.
Opposite to path dependence is having optionality, which makes it easy to adjust to unpredictable changes.
When the risks were defined and dealt with beforehand, when events happen and it’s easy to adapt, when there is no need to know how things will unfold, that is when you have optionality.
Our initial work with risk covered and has helped restrict the downside (remember: never 100% since it would be impossible) now we need to know how to reach the unlimited upside. We’ll cover that on the next part.
Recap
The basic process to control risks:
1 – Know what is the worst case scenario before taking action
2 – Find the best ways to deal with those scenarios and limit the downside
3 – Don’t rely on specific paths and have your options open
Trader’s Antifragility:
Optionality + Limited Downside + Unlimited Upside = Convexity
Disclaimer
Instead of the old cliché this is not financial advice... here are the five rules of science from Neil deGrasse Tyson:
(1) Question authority. No idea is true just because someone says so, including me.
(2) Think for yourself. Question yourself. Don't believe anything just because you want to. Believing something doesn't make it so.
(3) Test ideas by the evidence gained from observation and experiment. If a favorite idea fails a well-designed test, it's wrong. Get over it.
(4) Follow the evidence wherever it leads. If you have no evidence, reserve judgment.
And perhaps the most important rule of all...
(5) Remember: you could be wrong. Even the best scientists have been wrong about some things. Newton, Einstein, and every other great scientist in history -- they all made mistakes. Of course they did. They were human.
Science is a way to keep from fooling ourselves, and each other.
Special thanks to:
Marco Batalha for the invaluable help with proofreading.
Thank you very much for reading!
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