Sirwin
Sirwin
Y2K Finance

Market Crash Playbook

By fmiren | Real World Assets | 5 Jan 2024


Crypto creates opportunities for building generational wealth. Since it’s a relatively new market, it has many inefficiencies which can be and are exploited by savvy traders and investors. But as the classical financial theory claims high rewards can be attained by taking higher risks. In this sense, crypto is a double-edged sword. Opportunities to make 10X in a week is accompanied by the risk to go broke in a short time. Therefore, in order to enjoy the full potential of the crypto market we shouldn’t overlook its risks and hedge our positions against the market-wide collapse. It doesn’t matter what you think of the man, but I really like the following Donald Trump quote: “Protect the downside and the upside will take care of itself.”


TradFi solutions

There are many ways of protecting oneself against price swings in traditional finance. For example, stop-loss is a kind of market order which automatically price the security when it reaches a prespecified level. Let’s say, you buy SOLUSDT at the market price of 95. To hedge your position against price decrease you put a stop-loss order at 90. If $SOL falls to that level, you automatically close your position at 90 with a loss.

Another risk management tool which can be employed to hedge against falling price is a put option. Put option is a derivatives contract giving the option holder the right to sell the underlying asset at a predefined level within a specified time frame. Let’s say, you hold BTC which is trading around $43,000 at the moment. You think that the probability that BTC will crash and trade below $40,000 during the next 3 months is high. What you can do is to buy March 24 (put option contract expiring in March 2024) with the strike price $40,000. If the price falls below the strike price, you don’t have to sell your satoshis. Though your spot position is in loss, you are making profit with your put option.

DeFi-native risks and their solutions

Now let’s talk about more DeFi-specific tools against the market collapse. Perhaps the most important systemic risk in DeFi is stablecoin depeg risk. It is no exaggeration to say that the entire DeFi depends on stabelcoins. Lending, borrowing, liquidity providing, staking, trading – all of these would be impossible without them.

Stablecoins are generally perceived to be a safe haven in the crypto market. But in turbulent periods stablecoins, or at least some of them, tend to depeg, that is to lose their peg to a fiat currency which is typically USD. Sometimes stablecoins fail spectacularly showing that they are not stable at all. The infamous UST, a native stablecoin of the Terra ecosystem, fell to 0.006 USDT losing 99.4% of its value as a result of Terra blockchain collapse. On another note, albeit not as dramatic as the UST case, USDC, one of the largest stablecoins by market cap, lost its dollar peg in March 2023 as investors were concerned that the failure of Silicon Valley Bank will spread to entire banking system.

There are several DeFi insurance protocols offering stablecoin depeg cover. For example, at InsurAce you can buy a cover against USDC, USDT, and MIM depeg events. Y2K Finance, a protocol specializing in the hedging and pricing of pegged assets, allows to cover the depeg risk of many stablecoins, USDD, MAI, FDUSD, and LUSD among others.

 

Y2K Finance

 

If you are a true DeFi degen, you can be even more aggressive by shorting a stablecoin perp. Holding a stablecoin is like a short volatility strategy – most of the time nothing interesting happens and the coin keeps its peg. But occasionally it will depeg leading to large losses for investors. Shorting a stablecoin perp is exactly the opposite of this; it’s a long vol strategy: most of the time you’ll lose small being on the wrong side of the trade, but when the market crashes, you’ll win big.

Bumper Finance

Bumper Finance offers a novel way for crypto traders to protect against downside volatility. It’s kind of a combination of the features of stop-loss orders and put options. You benefit from the upside potential of your crypto asset while ensuring that your position cannot be liquidated. An example will clarify how the protocol works.

Let’s say you hold ETH. Your worst nightmare is that the second largest cryptocurrency can crash within the next, say, 14 days. To hedge the price decrease you select a term length and protection floor on Bumper. Term length in your case is 14 days; protection floor indicates to which level you want to protect your asset. If you think that ETH can fall 10% during the upcoming two weeks, you choose the protection floor of 90%. You pay premia and buy a protection. Your ETH is locked as long as your protection is active. You get synthetic Bumpered ETH, or bETH which is hedged against ETH price decrease. Another benefit of bETH is that, unlike your locked ETH, it can be used in other DeFi protocols. Since it has a minimum guaranteed value, it is not subject to forced liquidations

At the end of term length, one of the possible two outcomes will be realized:

1) ETH is trading below the protection floor. With the traditional stop-loss you’d lost your ETH. But with Bumper, you don’t lose the underlying asset, and you receive stablecoins.

2) No catastrophe occurs – ETH is trading over the protection floor. In this case, you just receive back your protected asset.

That’s the beauty of Bumper Finance. You are never stopped out of your position while retaining upside potential. And the cost (also called premium) is way cheaper than the traditional put options traded on Deribit, world's biggest Bitcoin and Ethereum options exchange, and other crypto options platforms. This is because unlike traditional option models, such as Black-Scholes, Bumper Finance uses actual volatility not historical volatility to calculate option premiums.

Inverse Bitcoin Futures ETF

If futures trading, especially short selling is not your game, another way of capitalizing on the crypto market crash is buying ProShares Short Bitcoin Strategy ETF. As its name suggests, this ETF seeks a return that is -1x the return of its underlying benchmark – the S&P CME Bitcoin Futures Index (“target”) for a single day. Put simply, it is the inverse of Bitcoin; if Bitcoin falls, ETF price rises, and vice versa.

 

inverse BTC futures

 

As the chart makes it clear, when the largest cryptocurrency was trading below $20,000, Short Bitcoin ETF reached its all-time high. Since then, it gradually falls with Bitcoin price relentlessly rising.

Bet on increasing BTC dominance

An increase in Bitcoin dominance indicates the weaker crypto market in general. It means that traders sell their riskier altcoins into Bitcoin which signals a risk-off sentiment. Conversely, in risk-on environments crypto traders choose to sell relatively safe BTC and ape in riskier cryptocurrencies which decreases Bitcoin dominance ratio. So, we can say that a market crash is accompanied and followed a rise in BTC dominance.

To buy BTC is not a way to benefit from what we said above. Because even the largest cryptocurrency falls during bear markets. We bet not on an absolute but a relative performance of Bitcoin. One can go long BTC/ETH pair assuming that ETH represents the altcoin market fairly well. Yet another, more direct trade would be buying BTCDOM token through Domination Finance. Domination Finance if the first DEX for dominance trading. If you think BTC dominance will rise, you can buy BTCDOM; otherwise, you short it.

Conclusion

Crypto is a new and complex market. As the industry evolves, novel, hidden and more complex risks arise. Therefore, it becomes increasingly hard to forecast what will cause the next market crash. It can be negative news on ETF approval, it can be exacerbating global macro environment, or it can be a factor which we don’t even know that it exists, that ethereal “unknown unknown”. In this article, we tried to shed some light on a few ways to protect your capital against market collapse, and if possible, to benefit from it.

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fmiren
fmiren

commodity trader interested in crypto & writing about it


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