How Traders Can Benefit from Market Dislocations in the Crypto Space

When (market turbulence) stress occurs in the traditional world there are many safeguards in place to ensure orderly markets.

These “guardrails” are put in place after learning the hard lessons of what has happened (the snowball effect of market volatility). Traditionally, excessive market volatility has been accompanied by meltdowns and central bank interventions (the latter less common), which allow market participants to pause, pause, evaluate and act accordingly, rather than being forced to make real-time decisions and margin calls. Having experienced a number of market events, many participants have come to a consensus on these rules to avoid suffering.

In the cryptocurrency market, protection measures are a completely foreign concept. Some participants in the cryptocurrency market have overblown true freedom as a selling point: as a beacon of a new era where anything is possible, a wild natural experiment for all to experience. Of course, this lack of security leads cryptocurrency investors to experience spectacular explosions (spikes) and crashes (plunges) every 6 months or so, as outsiders usually watch in fear.

As an active trader, you probably relish these moments. Overly volatile and fearful markets are often the best places to trade for those savvy market participants who can identify and take advantage of structural breakouts that occur on the way down. Exchanges fall, forced selling brings high EV buying opportunities, futures products deviate from their indices, options can reach extremely high IVs, and in-chain liquidation can drive arbitrage opportunities. All of this is a protable feast for bullet-rich market participants.

As a related example, on Deribit you can often see IVs pop due to market makers expanding the market or accounts being forced to become option buyers by clearing. Often, you can’t sell much at extreme IV levels, but often small investors can take advantage of these blowouts and sell options at extremely high levels with some confidence that the market volatility will revert to the mean after it subsides (usually within 12 to 48 hours of the initial blowout).

Back to 1987
On October 19, 1987, the Dow experienced its largest one-day decline, falling 22.6% in a single day amid massive panic and margin calls. This was the first animal spirits collapse experienced by traditional markets in the era of automated trading, and the pre-determined nature of many trading decisions (such as the widespread use of stop losses) exacerbated the sell-off.

At the time, most market participants were incredulous at the 20%+ drop in a short period of time, and the reaction to that drop was swift and violent. Regulators acted immediately to put safeguards in place to stop the cascade of panic and selling and to stop the snowball that was about to roll downward.

The main rule established was a trading pause. This “pause” approach was tested in real time during the 1987 crash, when the Nasdaq experienced an exchange failure and stocks on the exchange fell by only 11% cumulatively, about half the decline in the S&P 500. By January 1988, the SEC enacted regulations (now known as Rule 80B) requiring exchanges to halt trading in securities that reached volatility thresholds.

With the cryptocurrency space, we experience events like 1987 multiple times a year, where a combination of high leverage, collateral inefficiencies and animal spirits lead to sharp sell-offs, and large declines. Unlike the traditional world, the cryptocurrency world has few safeguards to prevent the plunge from happening again. Some exchanges like Deribit have introduced sub-second meltdowns (triggering a stop loss if the price fluctuates by more than 2.5% in a second), but the vast majority of exchanges have no such safeguards.

The May Crash
On May 19, 2021, Bitcoin plunged by about 20% in 45 minutes, then recovered over the next 2 hours.

The move was the result of widespread market weakness as spot buying evaporated and the market was overexposed to high beta assets with a lack of wait-and-see cash.

Over $3 billion in liquidation occurred on the day in bitcoin futures products alone, not including liquidation in cryptocurrency futures. The speed of the day’s liquidation and collapse sent the market into a frenzy with all sorts of misalignments. The mechanics of the sell-off have been widely discussed, and the discussion here will focus on this aspect of the market becoming disrupted by the violent and rapid volatility.

Futures + Spot
One of the most common scenarios in highly stressed markets is the liquidation of futures positions, which tends to push futures prices to the breaking point.

Due to the high demand for leverage in the market, futures products usually trade with positive spreads (meaning they trade at a higher price than the liquidation price in the spot market). This makes buying futures at the spot price (trading at a price lower than the spot market clearing price) an attractive opportunity. During this recent crash, Deribit’s quarterly bitcoin futures annualized rates fell to a low of -13% and ETH quarterly futures rates fell to a low of -23%.

How Traders Can Benefit from Market Dislocations in the Crypto Space

Both futures products quickly revert from an inverse to a positive spread state, and those who manage to get filled on these futures due to forced sellers will eventually be happy. This illustrates a simple example of market inefficiencies that can be exploited by savvy traders who watch the market closely. For those looking to establish a long position on the next “capitulation”, it may be wise to use futures as an alternative to buying spot during a decline.

Options IVs
Market makers tend to expand their markets on the options book when there is a large volatile event in the spot market, and liquidity can be extremely low due to the uncertainty of market conditions. In order to liquidate short options accounts, Deribit sometimes uses futures to hedge options risk, but also attempts to liquidate options positions by (usually) forming forced buys on certain strike prices and instruments.

Due to liquidation and volatile liquidity, you will often see extremely high implied volatilities, and once the market cools, you should be able to sell these implied volatilities as a relatively high expected value of that IV mean reversion. Note that in the recent market structure, DVOL actually broke out twice, once during the initial crash and then a second (and even more powerful) time during the pullback. Both of these large swings were met with pullbacks over the next 24 hours.

How Traders Can Benefit from Market Dislocations in the Crypto Space

Forced Selling
A more subtle version of market dislocation (dislocation) is the concept of “forced selling,” which is an aggressive EV for deploying new capital, betting that once liquidation and margin calls are complete, there will be a lack of natural selling at that price level, giving the asset the ability to rally sharply.

For example, Bitcoin rallied about 20% from its lows, Ether rallied about 35% and Uni rallied about 50% in one hour on May 19. These sharp upward moves became possible because a significant portion of the selling was forced out of the sale. Forced sales tend to happen at the most inopportune prices because liquidation is done in batches and under peak market pressure.

Most forced sellers will not want to sell at the price at which they exit if given the opportunity to do so. This is why incremental clearing systems that sell only part of a position at a time (such as Deribit’s system) are usually preferable to full clearing systems (from the client’s perspective) that sell the entire position when maintenance margin is reached.

Cascade clearing often offers some of the best buying opportunities. When clearing is fully completed, the market generally rallies higher because the main source of selling in the market has now weakened. It takes more expertise to take advantage of this inefficiency than to buy discounted futures or sell high on IV, but the opportunity is still there.

DeFi actually fared better than expected during this recent sell-off, with no major failures in key systems, yet that doesn’t mean there aren’t opportunities to take advantage of.

First, when the market reverses quickly, you often find lending platforms such as Compound and Aave have a lot of liquidation and sophisticated liquidation robots can take advantage of these opportunities.

Second, because AMMs rely on arbitrage to keep pricing consistent, rapidly changing markets on centralized exchanges often introduce huge price differences. Typically, price differences between centralized exchanges and AMMs like Uniswap and Sushiswap are too small for non-complex bots to take advantage of, but when markets change as quickly as they did on May 19, you will find that price differences are sufficient for bots with low levels of complexity.

In the golden age of dislocation, traders were fortunate to be able to take advantage of such opportunities. What is happening now will likely continue until there is enough idle money coming into the cryptocurrency ecosystem to smooth out the market. exchanges other than Deribit may work to introduce more market guardrails, which is good for market stability, but it is bad for those active traders.

Future regulation is also likely to target these issues to ensure a more orderly market, especially now that more investment firms are paying attention to potential ETFs.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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