How traders can benefit from market dislocations in crypto

In the traditional world, there are many safeguards to ensure that markets remain orderly when stress (market turmoil) occurs. These "guardrails" are set up after learning from the painful lessons that have happened (the snowball effect caused by market volatility). When traditional markets are over-volatile, there will be circuit breakers and central bank interventions (the latter is less common), which allow market participants to pause, pause, evaluate and act accordingly, rather than being forced to make real-time decisions and margin calls. After some market events, many participants have reached consensus on these rules to avoid suffering.

In the cryptocurrency market, safeguards are a completely foreign concept. Some of the cryptocurrency market participants have over-sold true freedom as a selling point: a beacon of a new era where anything is possible, a wild natural experiment that everyone can experience. Of course, this lack of safeguards leads to a spectacular explosion (pump) and crash (dump) every 6 months or so for cryptocurrency investors, and outsiders usually watch in horror.

As an active trader, you probably relish these moments. Markets of excessive volatility and fear are often the best places to trade for those savvy market participants who are able to identify and take advantage of structural breakouts that occur on the way down. Exchanges decline, forced selling presents high EV buying opportunities, futures products deviate from their indices, options can reach extremely high IVs, and on-chain liquidations can also drive arbitrage opportunities. These are all a feast for market participants who have ample ammunition.

As a relevant example, on Deribit you can often see IVs blow out due to market makers expanding the market or accounts being forced to become option buyers through liquidation. Typically you can't sell a lot at extreme IV levels, but often small investors can take advantage of these blowouts by selling options at extremely high levels with some confidence that the market will revert to the mean after the volatility subsides (usually within 12 to 48 hours after the initial blowout).

Back to 1987

The Dow Jones experienced its largest single-day drop on October 19, 1987, falling 22.6% in a single day amidst mass panic and margin calls. This was the first animal spirit breakdown that traditional markets experienced in the age of automated trading, and the sell-off was exacerbated by the preset nature of many trading decisions, such as the widespread use of stop losses.

At that time, most market participants were incredulous about a drop of more than 20% in a short period of time, and the reaction to this drop was swift and fierce. Regulators immediately took action and took safeguards to prevent a series of panic and sell-offs and stop the snowball from rolling down.

The main rule that was developed was to halt trading. This "halt" approach was tested in real time during the 1987 crash, when the Nasdaq experienced an exchange glitch and stocks on the exchange fell only 11% cumulatively, about half the decline of the S&P 500. By January 1988, the SEC had enacted regulations (now called Rule 80B) requiring exchanges to halt trading in securities that reached volatility thresholds.

In the crypto space, we experience 1987-like events multiple times a year, where high leverage, collateral inefficiencies, and animal spirits combine to cause sharp sell-offs and huge declines. Unlike the traditional world, the crypto world has few safeguards to prevent the crash from happening again. Some exchanges, like Deribit, have introduced sub-second circuit breakers (stops are triggered if the price moves more than 2.5% in a second), but the vast majority of exchanges have no such safeguards.

The May crash

On May 19, 2021, Bitcoin plunged by about 20% in 45 minutes, and then rebounded within the next 2 hours.

The move was a result of general market weakness as spot buying evaporated and there was a lack of cash on the sidelines due to the market’s overexposure to high-beta assets.

Over $3 billion was liquidated in Bitcoin futures products alone that day, not including altcoin futures liquidations. The speed of liquidations and crashes that day sent markets into a frenzy with all kinds of dislocations. The mechanics of the sell-off have been widely discussed, and the discussion here will focus on the market becoming chaotic due to the violent and rapid moves.

Futures + Spot

One of the most common occurrences in highly stressed markets is the liquidation of futures positions, which often pushes futures prices to extremes.

Due to the high demand for leverage in the market, futures products often trade in contango (meaning they trade at a higher price than the clearing price in the spot market). This makes buying futures at spot prices (trading at a lower price than the clearing price in the spot market) an attractive opportunity. During this recent crash, Deribit's quarterly Bitcoin futures annualized rate fell to a low of -13%, and ETH quarterly futures rates fell to a low of -23%.

Data:Skew.com

Both futures products quickly recovered from backwardation to contango, and those who managed to get filled on these futures due to forced sellers are ultimately happy. This is a simple example of market inefficiency that can be exploited by savvy traders who pay close attention to the market. For those who are looking to establish a long position at the next "capitulation," using futures as an alternative to buying spot during the decline may be a smart move.

Option IVs

When there are large volatility events in the spot market, market makers tend to expand their markets on the options book, and liquidity can be extremely low due to uncertainty in market conditions. To liquidate accounts that are short options, Deribit sometimes uses futures to hedge option risk, but also attempts to liquidate option positions, creating forced buys on certain strike prices and instruments (usually).

You will often see extremely high implied volatility due to liquidations and volatile liquidity, and once the market cools off, you should be able to sell these implied volatilities as a relatively high expected value for this IV mean reversion. Note that in the recent market structure, DVOL actually broke out twice, once during the initial crash, and then a second (even more forceful) one during the pullback. Both of these large moves were met with pullbacks within the next 24 hours.

Data: Deribit.com

Forced Sell

A more subtle version of market dislocation is the concept of "forced selling," which is deploying new capital at an aggressive EV, betting that once liquidations and margin calls are complete, there will be a lack of natural selling at that price level, giving the asset the ability to rebound sharply.

For example, Bitcoin rebounded about 20% from its lows within an hour on May 19, Ethereum rebounded about 35%, and Unicoin rebounded about 50%. These sharp upward moves were possible because a significant portion of the selling was forced selling. Forced selling often occurs at the most inappropriate prices because liquidations are carried out in batches and at peak market pressure.

Most forced sellers will not want to sell at the price they exited at if given the chance. This is why an incremental liquidation system (like Deribit's) where only part of the position is sold at a time is generally superior (from the client's perspective) to a full liquidation system where the entire position is sold when the maintenance margin is reached.

Cascading liquidations often provide some of the best buying opportunities. When the liquidations are fully completed, generally the market will rebound higher because the major source of selling in the market has now diminished. It takes more expertise to take advantage of this inefficiency than buying discounted futures or selling high-priced IVs, but the opportunity is there.

DeFi

DeFi has actually held up better than expected during this recent sell-off, with no major failures in key systems, however this does not mean there are no opportunities to exploit. First, when markets reverse quickly, you often see large liquidations on lending platforms such as Compound and Aave, which sophisticated liquidation bots can exploit.

Second, because AMMs rely on arbitrage to keep pricing consistent, fast-moving markets on centralized exchanges often introduce large price differences. Normally, the price differences between centralized exchanges and AMMs like Uniswap and Sushiswap are too small for non-sophisticated bots to exploit, but when the market moves as fast as it did on May 19, you’ll find that the price differences are large enough for even low-sophistication bots.

in conclusion

In the golden age of dislocation, traders are lucky enough to be able to seize such opportunities. The current situation may continue until enough idle funds enter the cryptocurrency ecosystem to achieve market smoothing. Other exchanges besides Deribit may work to introduce more market guardrails, which is good for market stability, but bad for active traders.

Future regulation may also target these issues to ensure a more orderly market, especially now that more investment firms are paying attention to potential ETFs.