Leveraging Volatility in your Favor

Crypto assets are considered risky because of their volatility. But what if you can learn to leverage it in your favor? The Volatility Harvesting (VH) strategy does exactly that! Rebalancing that aims to buy low and sell high can harvest excess returns from the volatility of the underlying assets. Portfolio managers can harvest more volatility through rebalancing as the volatility of individual assets increases.

We look at how you can benefit from volatility.

Limits of Dollar Cost Averaging

Dollar-cost averaging (DCA) is a widespread technique consisting of buying a certain amount of tokens periodically, regardless of price.

Example: I want to invest $10,000 in Bitcoin. I buy $100 worth of Bitcoin every day for 100 days; that is it. The rationale?! I don’t know what the price will do. It can go a little bit up, then down; who knows? So, I split my buy order into lots of little orders. If the price trends are down, I will get a more favorable average purchase price.

In this case, DCA is a technique more than a strategy, as it does not tell you when to sell or at least rebalance your holdings. It is just a technique that helps you accumulate tokens.

Principles Behind Volatility Harvesting

Volatility harvesting is a concept that gigabrain mathematician Claude Shannon elaborated on. The strategy that can be derived is an extension and generalization of DCA.

Example: Imagine a token going up and down continuously, staying around some value. For instance, buy a token at $100, then the next day token price will be $101, $99, $101, and so on. In this case, you are not having any return on your investment.

However, what happens if you instead rebalance the portfolio?

You started with $100. When the token goes up by $1, you sell one dollar equivalent of the token. You know, have $100 invested in tokens and $1 in cash. When the price goes down to $99, your portfolio value will be $100: $99, the value of the token plus $1 in cash!

The difference is that when you buy and hold, it is down $1, while the portfolio is flat. When the price goes up again to $101, you sell $1 worth of the token, and your portfolio is now worth $102! The nice thing is that if the price drops, let us say to 97$; we have some cash to buy lower.

If volatility is higher, the effect of rebalancing is even more powerful. Think about what happens to a rebalanced portfolio for a token that moves to $110, then $90, then again to $110.

The major takeaways from this strategy are;

• It is essential to rebalance the portfolio

• It is helpful to have some cash in the portfolio.

The VH strategy has two parameters: the weight of cash and the rebalancing threshold.

Lowering the rebalancing threshold leads to more frequent rebalancing and higher trading fees. I think 50% and 5% are suitable parameters, working fine, but you are free to experiment. You can apply the strategy also to a diversified basket of tokens—the same rules.

Final Thoughts

Volatility, in most cases, is a nightmare to traders. However, we can always use it to our advantage. Its main benefits include the stance that it buys low and sells high. Additionally, it never runs out of cash.

Lastly, the strategy outperforms buy and hold in two of three scenarios.

Now, volatility becomes your friend.