Markets blow up, so ‘the best prep is to have a plan to buy fear and sell euphoria’ — Veteran trader

Global markets blew up over the weekend, and the onslaught carried on throughout the trading day on Aug. 5 as the DOW and S&P 500 dropped by more than 1,000 points and Bitcoin (BTC) price fell below $49,000. Japan’s Nikkei 225 index saw its worst one-day correction since October 1987, and the sell-off in Taiwan’s benchmark stock index was the worst trading day in 57 years. 

Nearly all markets closed Aug.5 in the red, and while it seems too early to conclude that the selling is over, traders are likely wondering whether or not it’s time to start thinking like a contrarian and handpicking assets at a discount?

To discuss what’s happening in this week’s volatile market, Cointelegraph spoke to Huf, the founder of Pear Protocol, a decentralized exchange that allows traders to engage in trending narratives via pair trading.

Cointelegraph: From your point of view, is there something traders are drastically wrong about regarding the current crash in global markets and crypto?

Huf: Market participants are overwhelmingly positioning for a Q4 rally, with upside catalysts including rate cuts, a civil transition to a new government in the US and other crypto specific tailwinds such as FTX creditor repayments.

In my opinion they are less aware that if we start aggressively cutting, this will lead to sustained downside pressure on the dollar and specifically USDJPY. TradFi deleveraging takes place over days and weeks, whereas in crypto it’s usually over in one cascade. This further downside in USDJPY can lead to a second round of yen carry trade unwinds.

Elections are usually positive equity market catalysts but given the divided nature of US society, a less than peaceful transition to a new government is a risk - including prolonged protests that morph into nationwide riots. Some other countries such as Iran and Russia may take advantage of a distracted White House and increase their military operations abroad.

Lastly, the US Government is yet to sell a substantial portion of their seized Bitcoin assets. A large portion of those coins (outside of Silk Road) are embroiled in a legal battle with BitFinex and its users. If they were to win and receive the Bitcoin, coins which had previously essentially been out of circulating supply could hit the market then we could see a Mt. Gox part 2 style fear, offsetting the FTX tailwind.

CT: As a trader, is there a lesson to be learned or a better way to prepare, play or hedge against events like the last few days?

Huf: Summer liquidity is always lower than the rest of the year, so preparing for this seasonality is key. Traders should either size down (use less leverage) in these summer months to account for this difference in market structure and/or increase your cash allocation to improve your average entry price.

Whilst tempting to think one could have simply bought VIX futures - the reality is that most of the time the vix is in contango and holding/rolling to expiry has been an expensive and fruitless endeavour.

We’ve been trending down since April in crypto. One technique for such choppy and bearish conditions is to pair trade - i.e. you build a portfolio of long assets and offset the risk with a corresponding basket of shorts. For example, a user may still want to be long Bitcoin but be worried about drawdowns like today. One idea would be to be long Bitcoin and short something like Litecoin or ADA. You benefit from the upside when markets trend as moves tend to be bitcoin led, whilst the short leg provides protection on the downside.

As always, the best form of preparation is to have a plan to buy fear and sell euphoria. What’s made this market hard is compared to previous cycles where dogcoins marked a clear local top, the memecoin mania extended for several weeks and months giving the illusion of sustainability. When you next see a limited pool of capital constantly rotating between narratives it will be an indicator of late cycle behaviour.

CT: Is there a better way to position directionally than just looking at potential mean reversions on deeply oversold assets like BTC, ETH and SOL?

Yes, one of the misconceptions about pair trading is that you give up too much upside. That’s not necessarily true due to the use of cross margin and sensible leverage. For example, a user may anticipate a +10% move up in SOL. This clearly carries a lot of risk to the downside.

However, trading something like SOL/ETH allows a user to capture a say 5% move instead and can be done with leverage of 2x. The gains on the long SOL leg offset any potential loss of being short ETH into a raising market.

However, the real power of this strategy is on the downside. Say SOL was to move down -5%, and ETH fell -10%, then the user is still making money regardless of if the broader market went up or down.

Whilst pair trading is not market-neutral per se due to the beta and vol of the two assets, it does provide a compelling way to amplify your view using leverage, whilst shielding you from liquidation risk.

Other instruments are starting to make their way over from TradFi including 0dte options on crypto, currently being pioneered by the likes of IVX (on Berachain).

CT: Do you think the negative funding in large caps is a head fake?

Huf: Funding has some idiosyncratic elements to it depending on the asset and the venue. For example, ETH funding is historically low partly driven by Ethena labs and the issuance of its stablecoin, the mechanism for which systematically sells ETH perps and keeps a lid on funding costs. Funding has been varying across different trading platforms too based on whether their users are aggressively long or short, so it often says more about a user base and their conditioned response (like shorting the lows) than signalling where markets may go next.

The reality is a lot of people have lost a lot of money and are revenge trading, and thus dialling up the leverage and getting stopped out before higher funding can really reset and kick in.

CT: Do these margin calls and unwinds in TradFi that we saw this week take a few days to wash out compared to crypto, and does that mean that any immediate oversold bounce in crypto is a trap?

Huf: Yes, there are two types of TradFi selling to be aware of. Discretionary and algorithmic. When vol spikes like it has - a combination of momentum funds, risk parity algos, CTAs and other systematic strategies flip their signal and start selling risk assets including equity futures. Once volatility dies down, the models reset and the trend goes back to neutral. However, discretionary allocation is often a lot slower. This involves risk and asset allocation committees slowing unwinding either in an OTC fashion or processing their trades in smaller clips so as to panic sell.

CT- Many analysts have long expected the US Federal Reserve to cut rates and on Aug.5, Wharton’s Jeremy Siegel said the Fed needs to make an emergency rate cut. Meanwhile, author Parker Lewis said “It doesn’t get interesting until the Fed starts cutting rates. Max pain happens after that.”

What’s your take on rate cuts, and the true short and long-term impact they could have on equities and crypto markets?

Huf: It depends on the market context. The Fed is cutting into an economy that has been relatively strong - with GDP and employment pretty robust up until this latest NFP datapoint. Rate cuts (much like rate hikes) produce a delayed response in terms of looser credit conditions and higher consumption/spending.

In the short term, thankfully the market has gotten ahead of itself expecting a very aggressive path of rate cuts. If and when this doesn’t manifest, it can lead to some relief especially if the economic data is good. In the long term, the bigger risk to a society is always inflation and thus the lever of interest rates has shown to be an effective tool in controlling that.

Either way, prepare for more volatility into year end as expectations have unhinged from reality.