Back in the middle of December, I was brought into a group text conversation about – what else – Bitcoin.
“I’m just going to buy it and ride this uptrend for as long as it lasts. What do you think, Charlie?”
I’m not sure you’re going to like this answer, but here goes…
If we define an uptrend as an asset trading above its 200-day moving average, Bitcoin has been in one for over two years now: since October 11, 2015. Over this period of time, Bitcoin has advanced over 7,700%. In choosing to “ride the uptrend” today, you will receive none of these gains but will incur all of the downside risk until the trend changes.
The price of Bitcoin today, $19,343, is 272% above its 200-day moving average of $5,201. That means if you bought today with the intention of holding it until it broke its 200-day moving average, you would have to be willing to lose at least 73%.
Source: Pension Partners, Coindesk
“73%! That’s crazy. How do you figure?”
If Bitcoin were to crash tomorrow and decline 73%, it would break its 200-day moving average and you would (as an avowed trend follower) be obligated to sell. While a 73% crash in one day is unlikely, such declines in Bitcoin over longer periods are not unprecedented:
- In 2010, it decline 94% over a period of 3 weeks.
- In 2011, it declined 94% over a period of 5 months.
- From April to July in 2013, it declined 76%.
- From December 2013 to January 2015, it declined 85%.
“But couldn’t I just sell it before it goes down that much?”
Sure you could, but that would be a subjective decision, not trend following. Trend following is supposed to be entirely objective in terms of buys/sells. The buys/sells may be worse at times than your subjective decisions, but that is the nature of a systematic strategy.
“This all seems really complicated. Everyone seems to be getting rich without knowing anything more than HODL.”
What Happened Next?
Bitcoin peaked that very day. Then it went down. Then it went down some more.
Last week Bitcoin broke below its 200-day moving average for the first time since October 10, 2015. From its high in December to the break of the 200-day moving, it had declined over 59%.
Source: Pension Partners, Coindesk
From its peak last December to its low last week it had declined 70%.
Does this mean that trend following in Bitcoin “doesn’t work?”
No. It’s a reminder that trend following is not a panacea (for further research on this, see here and here). Trend following is just a strategy, and one that’s often misunderstood to be about riding trends higher when in reality it is about controlling risk to the downside. But in an asset class that has gone parabolic, controlling downside risk can be quite challenging. Bitcoin was merely the latest example of this.
Since February 2011, a buy-and-hold of Bitcoin has generated an annualized return of 277% versus 250% for a trend following strategy that moves from Bitcoin to cash based on closes above/below its 200-day moving average. The modest benefit from trend following in this case: lower volatility (94% vs. 106%) and lower maximum drawdowns (-90% vs. -93%).
Data Source: Coindesk. Note the table above does not include transaction costs/fees/taxes. If included, returns would be lower, particularly for the trend following approach.
During the strongest up periods, trend following will often lag buy-and-hold as you miss the initial move or are whipsawed along the way. It is only during periods of significant and sustained weakness that trend following provides the largest benefits: when an asset breaks down, you get out, and it keeps on moving lower. The dream scenario: you avoid significant downside and re-enter at a much lower price when a new uptrend begins.
Whether trend following is favorable or unfavorable going forward will depend entirely on the path of returns. Unfortunately, this path is unknowable meaning the effectiveness of “following the trend” is unknowable as well. The best we can say is that over long periods of time trend following strategies have the ability to mitigate risk. Anything more than that is pure speculation.Subscribe to NFTRH Premium for an in-depth weekly market report, interim updates and NFTRH+ chart and trade ideas; or the free eLetter for an introduction to our work. You can also keep up to date with plenty of actionable public content at NFTRH.com. Or follow via Twitter @BiiwiiNFTRH, StockTwits or RSS. Also check out the quality market writers at Biiwii.com.