When stress appears in the traditional world, there are many guardrails to ensure that the market is in order. These rails have been placed after learning a hard lesson about the snowball effect that can occur in volatile markets. Things like meltdown mechanisms and central bank intervention (less common) occur during periods of excessive volatility in traditional markets because they allow market participants to pause, breathe, evaluate and take action rather than being forced to make real-time decisions and margin calls. Through first-hand experience with market events, many participants have come to agreement on these rules to avoid pain.
In the crypto market, this is a completely foreign concept. Participants in the cryptocurrency market use the essence of true freedom as a selling point, a beacon of a new era, a wild natural experiment that all can experience. Of course, this lack of safeguards leads crypto investors to experience spectacular outbursts and crashes every 6 months or so, and outsiders usually watch with fear.
As an active trader, you enjoy these moments. Overly volatile and fearful markets are often the best markets to trade for those savvy market participants who can identify and take advantage of the frequent structural breakouts that occur during these drawdowns. Exchanges fall, forced sell-offs present high EV buying opportunities, futures products deviate from their indices, options can reach extremely high IVs, and in-chain liquidation can drive arbitrage opportunities. These are all verifiable feasts for market participants with cash to deploy.
As a related example, on Deribit you can often see IV spikes as market makers expand their markets or accounts become forced option buyers through liquidation. Often, you cannot sell large volumes at extreme IV levels, but often small investors can take advantage of these bursts to sell options at extremely high levels with relative confidence that once the market volatility subsides (usually for will occur within 12 to 48 hours of the initial burst).
Back to 1987
On October 19, 1987, the Dow Jones fell 22.6% in one trading day, the largest single-day decline, due to mass panic and margin calls. This was the first mental breakdown 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, a 20%+ decline in a trading day was profoundly unpredictable for most market participants, and the market reacted quickly and violently to the decline. Regulators took immediate action to ensure precautions were in place to stop the chain reaction of panic and forced selling, which in their view was an avoidable snowball.
The main rule developed was the concept of a trading pause. This “pause” approach was actually tested in real time during the 1987 crash, as the Nasdaq experienced an exchange failure that saw the exchange’s stocks fall by only 11%, or about half the rate of the S&P 500. Thus, regulators could point to a natural experiment, and by January 1988, the Securities and Exchange Commission (SEC) was working on regulations (now known as Rule 80B) that would require exchanges to suspend trading in securities that reached specific volatility thresholds.
The most similar situation to the ongoing capital drawdown in cryptocurrencies is that we experience events similar to 1987 multiple times a year, where a combination of high leverage, collateral inefficiencies and a spirit of panic leads to significant sell-offs. Unlike the traditional world, the crypto world has done little to prevent it from happening again. Some exchanges like Deribit were aggressive and introduced sub-second blocking mechanisms (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 protections to ensure that the crypto space can take the lead in these drawdowns over time.
On May 19, 2021, Bitcoin plunged about 20% in 45 minutes and then retraced the entire plunge over the next 2 hours. This move was the result of general market weakness caused by the evaporation of spot buying and the market’s over-exposure to high beta assets and lack of off-exchange funding.
Over $3 billion of liquidation occurred in Bitcoin futures products alone that day, not including liquidation of cryptocurrency futures. The speed with which the market liquidated and collapsed that day sent the market into a frenzy with all sorts of chaos. The mechanics of the sell-off have been widely discussed, so much of the discussion will focus on areas where the market became disconnected due to the violent and rapid volatility.
Futures + Spot
One of the most common events in highly stressed markets is the unwinding of futures positions, which usually pushes futures prices to extremes.
Due to the high demand for leverage in the market, futures products usually trade at a futures premium (meaning they trade at a higher price than the liquidation price in the spot market). This makes it an attractive opportunity to buy futures at a spot premium (trading at a price lower than the clearing price in the spot market). During this recent crash, the annualized bitcoin quarterly futures rate for derivatives fell to a low of -13% and the ETH quarterly futures rate fell to a low of -23%.
Both futures products quickly recovered from a spot premium state to a futures premium state, and those who managed to fill those futures due to forced selling ended up very happy. This is a simple example of market inefficiencies that can be exploited by savvy traders if they pay close attention. For those looking to establish a long position on the next “capitulation”, it may be wise to look for futures as an alternative to buying spot during a decline.
Market makers often expand their markets on the options book when there is massive volatility in the spot market, and in some cases you may find very little liquidity due to the uncertainty of market conditions. To liquidate short options accounts, Deribit sometimes uses futures to hedge options exposure, but also tries to get rid of options positions – creating (usually) mandatory purchases of certain strike prices and instruments.
Due to liquidation and volatile liquidity, you will often see extremely high implied volatility, which you should be able to sell as a relatively high expected value once the market cools down. 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.
A more nuanced version of market dislocation is the concept of “forced selling” as a positive place to allocate new capital, betting on the idea that once liquidation and margin calls are fully passed, there will be a lack of natural selling price levels, giving assets the ability to rally significantly.
For example, Bitcoin rallied about 20% from its lows, Ether rallied about 35%, and Uni rallied about 50% in a single hour on May 19. These large rallies were possible because a large portion of the sales were forced sales. Forced sales usually occur at the most untimely prices, as batch liquidations occur during peaks in market pressure.
Most forced sellers will not be inclined to sell at the price they were at when they exited, if given the opportunity to do so. This is why an incremental clearing system that sells only a portion of your position at a time (such as the one owned by Deribit) is usually preferable (from the client’s point of view) to a full clearing system that sells your entire position when maintenance margin is reached.
Cascade clearing usually presents some of the best buying opportunities. When liquidation is complete, the market usually rallies higher because the main source of selling in the market has now weakened. It takes a little more expertise to take advantage of this inefficiency than buying discounted futures or selling overpriced IVs, but the opportunity still exists.
DeFi actually performed better than expected during this recent sell-off, with no major failures in key systems – but that doesn’t mean there aren’t opportunities to take advantage. First, when the market reverses quickly, you often find a lot of liquidation from lending platforms like Compound and Aave, which sophisticated liquidation bots can exploit.
Second, because AMMs rely on arbitrage to keep pricing consistent, rapidly changing markets on centralized exchanges often introduce huge price discrepancies. Usually, the price differences between centralized exchanges and AMMs like Uniswap and Sushiswap are too small for non-complex bots to take advantage of, but when the market changes as quickly as it did on May 19, you will find that price differences are enough even for ordinary bots.
In the golden age of chaos, traders are fortunate to be able to take advantage of such opportunities. These conditions will likely continue until enough idle money enters the crypto ecosystem to clearly smooth out market operations. exchanges other than Deribit may work to introduce more market guardrails – which would benefit market stability, but not those active traders.
Future regulation may also address these issues to ensure a more orderly market, especially as more and more investment firms focus on potential ETFs.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/what-about-the-market-crash-do-not-panic-learn-these-operations-to-make-money-becomes-so-easy/
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