How to Generate Bitcoin Trading Alpha?

If you’re new to Bitcoin and still learning the ropes as an investor or trader, you may be looking for the elusive “alpha”, also known as risk free return. While easy to understand in principle, the reality is that true alpha is tough to find. Let's break down how you can generate alpha for your trading portfolio.

Understanding Alpha

So we want to earn alpha, but what exactly is it? The term originates from the first letter of the Greek alphabet (α) which then became used by investors to represent an investment or trading opportunity that generates a return higher than typical market returns (β).

Due to the fact that the stock market itself is perceived to be efficient, when an individual earns a return that exceeds stock market beta, they’d be known to generate “alpha”. Most of these types of trades or investments are when traders take advantage of information that the wider public doesn’t have access to or when the financial markets represent mispricing opportunities that allow traders to earn “risk free” returns.

Chasing Alpha in Digital Assets

As mentioned, global financial markets are typically relatively accurately priced. This is the “efficient markets” hypothesis that assumes that all information is perfectly distributed, allowing all investors and traders the ability to make the same decisions.

In reality, this is NOT the case for many reasons, the most important of which are:

1. Individuals do not always act rationally or logically (given human emotion often overrides their rational behaviour, especially in times of panic and exuberance).
2. The financial market is an aggregation of millions of trades across a variety of sectors and industries of different sizes, resulting in an unequal rate of information dissemination across the world (i.e. not all traders may be aware of arbitrage opportunities in certain niche/immature industries).

This is precisely why digital assets are an area of interest for so many traders. The digital assets industry is both:

• Smaller in Size
  The market cap of the entire digital asset industry currently stands at ~$3.4 trillion vs the NYSE which has a market cap 8x larger of ~$25 trillion.

• More Volatile:
  When compared with the NYSE, the digital asset sector has a lack of regulation, allows for 24/7 trading, and has limited circuit breakers . All of which contribute to the digital asset sector’s substantially more volatile price swings, making it perfect for opportunistic traders to take advantage of the irrational behaviour of market participants.

How to Generate Alpha [The Set Up]

So now that we know what alpha is, how do we earn it? Well the simple answer is to find opportunities that are being mispriced by the global financial market. This is easier said than done, given the fact that you’re competing with the rest of the world, all of whom are chasing the same “risk free” returns you are.

There are a few ways to tilt the odds in your favor though:

1. Find a niche market that has substantial volatility and is relatively illiquid:
   We’ve already covered digital assets as a niche segment of the market, but there are other asset classes out there (such as commodities or early stage tech startups). 
2. Download software (i.e. a charting platform) that enables you to easily acquire the asset(s) you’re looking to buy/trade:
   There are various options out there, so tend to focus on those that have the lowest trading fees and (more importantly) cover the widest amount of trading venues (the larger the number of trading venues, the higher your chances are of spotting that an asset is mispriced by the market).
3. Implement risk mitigation strategies to succeed over the long run:
   Perhaps the most important part of your strategy is to ensure you never lose your capital, often easier said than done. To remain solvent, standard practice is to set in place tight stop losses, create rules that limit how much of your money is ever at risk (the 2% rule) and keep a journal of your trades to promote self awareness of your own behaviour.

How to Spot a Alpha [The Implementation]

Having followed the above “set up” steps, you’re ready to begin chasing alpha and scanning the digital asset markets for mispricing opportunities. The process itself is unique to each individual, however the broader themes would encapsulate the below thematic steps:

1. Identify Broader Market Cycle:
   First we’d need to identify whether we’re in a bull or bear market. A good place to start is the Bitcoin halving cycle (Bitcoin’s price typically bottoms ~12-18 months prior to each 4-year halving), however there are various other indicators to analyse including global liquidity and crypto volatility indexes.
2. Study On Chain Data
   One of the most unique things about the blockchain is that it represents a public record of all transactions. As such, we’re able to identify the holdings and transaction flow of each individual wallet and thus, their investing behaviours. Hodl waves, MVRV Z-Score and wallet distribution of large coin holders (‘whales’) can all provide insightful information that can help identify when large, volatile price fluctuations are likely to occur. Tools such as Glassnode or Arkham Intelligence are extremely useful in this regard.
3. Exploit Arbitrage
   True risk free return typically only exists for small portions of time given the strong incentive from all the individuals who make up the financial markets to exploit. However, often during periods of extreme volatility, there exists the ability to take advantage of true arbitrage. This comes in three forms, namely:

• Funding Rate Arbitrage:
  Occurs when funding rates invert in perpetual markets, allowing traders to go  long spot and short futures to earn a “risk free” profit. [Tools like Coinglass allow traders to easily track this data].
• Geographic/Exchange Dislocation:
  Occurs when the price of Bitcoin (or any digital asset) in one country or on a specific exchange is higher than another. [TabTrader is an excellent tool to track pricing variations]
• Derivative Mispricing:
  Occurs when options markets mispricing volatility. [Deribit or Hyperliquid offer the ability to construct profitable spreads to profit from market mispricing]

Conclusion

Hopefully this article has given you some insight into how to best identify and trade alpha in the digital asset markets. It won’t be easy trading digital assets because you’re likely to be subject to the same irrational decision making that the rest of the market is subject to. However, if you’re able to remain unemotional and consistent with the above strategies, you’re bound to be successful in the long run.