Relative Value Trading in Crypto: A Biturai Deep Dive

Relative Value Trading: Unveiling the Crypto Arbitrage

Imagine you're at a market, and two stalls sell apples. One stall sells them for $1, the other for $1.20. If you’re a savvy shopper, you’d buy from the cheaper stall and, if possible, sell to the other. Relative Value Trading (RVT) in crypto is similar, but instead of apples, we're comparing similar cryptocurrencies or related financial instruments. It's about finding temporary price discrepancies and profiting from their eventual convergence.

Key Takeaway: Relative Value Trading capitalizes on price inefficiencies between related assets, anticipating their prices will eventually realign.

Definition

Relative Value Trading (RVT) is a trading strategy that aims to profit from the perceived mispricing between two or more related assets. The strategy is based on the expectation that the price difference between these assets will eventually narrow or converge to their 'fair value'.

In the crypto world, this could involve comparing the price of Bitcoin (BTC) to that of Bitcoin Cash (BCH), or the implied volatility of Ethereum (ETH) options to the implied volatility of Bitcoin options. The trader doesn’t necessarily care about the overall direction of the market (bull or bear); they are focused on the relationship between the assets.

Mechanics

Let’s break down how RVT works step-by-step:

Identification: The first step is to identify assets that are related or have a historical correlation. Examples include:
- Different versions of the same protocol: Bitcoin (BTC) and Bitcoin Cash (BCH), or Ethereum (ETH) and Ethereum Classic (ETC).
- Similar assets: Two different stablecoins pegged to the US dollar (e.g., USDT and USDC).
- Derivatives: Futures contracts on the same underlying asset but with different expiry dates.
- Tokens within the same ecosystem: Tokens of different projects built on the same blockchain.
Analysis: The trader analyzes the price relationship between the selected assets. This involves looking at:
- Historical correlation: How have their prices moved in relation to each other in the past? This is often quantified using correlation coefficients.
- Price discrepancy: Is there a significant divergence from the historical norm? Is one asset trading at a premium or discount relative to the other?
- Fundamental analysis: Are there any fundamental reasons (e.g., news, upgrades, network activity) that could explain the price difference? Is the market correctly pricing in these factors?
- Volatility analysis: Are there opportunities in comparing the implied volatility of options on the assets? How do the volatility surfaces compare?
Trade execution: If the analysis reveals a mispricing, the trader will execute a trade to profit from the expected convergence. Common strategies include:
- Pairs trading: Simultaneously buying the undervalued asset and selling the overvalued asset. This strategy aims to profit from the narrowing of the price difference.
- Spread trading: A more complex strategy, often used in derivatives, where a trader takes a position on the difference between the prices of two related assets. For example, buying a BTC futures contract and selling an ETH futures contract, hoping the difference in their prices will change in their favor.
- Basis trading: Exploiting the difference between the spot price of an asset and its futures price. If the futures price is significantly higher than the spot price (a situation called contango), the trader might sell the futures contract and buy the spot asset.
Monitoring and exit: The trader continuously monitors the trade to ensure the price relationship is moving in the expected direction. The trade is typically closed when the price difference has narrowed to the target level, or if the market conditions change and the trade is no longer viable.

Trading Relevance: Why Prices Move and How to Trade It

Several factors can cause price discrepancies that RVT traders can exploit:

Market Inefficiencies: Crypto markets, particularly for newer or less liquid assets, can be inefficient. Information doesn't always flow perfectly, and trading activity can be concentrated, leading to temporary mispricings.
News and Events: Significant news announcements, protocol upgrades, or regulatory developments can impact the prices of related assets differently, creating opportunities. For example, a positive announcement about Bitcoin might cause its price to increase more rapidly than Bitcoin Cash, creating a potential RVT opportunity.
Liquidity Differences: Different exchanges or trading pairs may have varying levels of liquidity. This can lead to price discrepancies, especially during periods of high volatility or order imbalances.
Arbitrage Opportunities: While pure arbitrage (simultaneously buying and selling the same asset on different exchanges) is a form of RVT, it's often very short-lived. RVT, however, can focus on less obvious relationships.
Sentiment and Speculation: Market sentiment can drive prices away from their 'fair value'. Traders can exploit this by betting on a reversion to the mean.

How to Trade:

Pairs Trading: Identify two assets with a strong historical correlation. If the correlation breaks down, and one asset significantly outperforms the other, short the outperforming asset and long the underperforming one. This is a market-neutral strategy, meaning you're not betting on the overall market direction.
Volatility Spreads: Use options to trade the difference in implied volatility between two assets. If you believe the implied volatility of ETH options is too high relative to BTC options, you could buy ETH options and sell BTC options.
Cross-Asset Spread: Use volatility surfaces to find opportunities. If one believes BTC and ETH tend to mean-revert toward historical correlations, any deviation in implied volatility might be a signal to set up a relative-value trade (sometimes referred to as a spread or pairing strategy) to profit as these volatilities converge again.

Risks

Relative Value Trading isn't without its risks:

Correlation Breakdown: The most significant risk is that the historical correlation between the assets breaks down. This could be due to unexpected news, a change in market dynamics, or a fundamental shift in the assets' underlying value.
Volatility: RVT strategies can be sensitive to volatility. Unexpected surges in volatility can lead to significant losses, particularly in options-based trades. Understanding and managing implied volatility is crucial.
Liquidity Risk: If one of the assets is illiquid, it can be difficult and expensive to enter or exit a trade, potentially leading to slippage and losses.
Execution Risk: The speed and efficiency of trade execution are critical. Delays or errors in execution can negate the expected profit or even lead to losses.
Unexpected Events: Black swan events (unforeseen events with significant consequences) can dramatically impact market correlations and wipe out RVT positions.

History/Examples

Bitcoin and Bitcoin Cash: Following the Bitcoin hard fork in 2017, the prices of BTC and BCH initially diverged significantly. RVT traders could have exploited this by shorting BCH (if they believed BTC would be the dominant chain) or long BCH (if they believed BCH would gain adoption). The price relationship has continued to evolve since.
Stablecoin Arbitrage: Throughout the life of crypto, opportunities to trade between different stablecoins (e.g., USDT, USDC, BUSD) have arisen. Traders watch for deviations from the $1 peg and trade accordingly. This is a form of RVT, but with a simpler target (convergence to $1).
Derivatives Spreads: Traders regularly trade spreads between futures contracts of Bitcoin or Ethereum with different expiration dates. For example, if the difference in the price of a Bitcoin futures contract expiring in one month versus three months is too high or too low compared to historical averages, an RVT trade can be initiated.
Implied Volatility Spreads: With the rise of crypto options, traders can compare the implied volatility of different assets. If the implied volatility of ETH options is significantly higher than that of BTC options (or vice versa), even though the underlying assets have similar characteristics, a trader might initiate a RVT trade.

Relative Value Trading is a sophisticated strategy that requires a deep understanding of the assets involved, market dynamics, and risk management. It's not a get-rich-quick scheme, but a way to potentially profit from market inefficiencies. It is critical to conduct thorough research, understand the risks, and have a well-defined trading plan before engaging in RVT.