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Digital assets: From passive investments to active strategies | Image by Shutter Speed
By employing tools like staking, lending, and yield-generating derivatives, investors can unlock new dimensions of portfolio performance. These approaches not only generate consistent yield but also enhance risk-adjusted returns while maintaining exposure to the broader market's growth potential.
To gain a deeper understanding of these strategies, watch the recording of our recent webinar, and read our report 'From holding to earning: Make your digital assets work for you', where we explore how to capitalize on the earning of digital assets through structured, professional-grade approaches.
Strategic allocation for long-term success
In the volatile world of digital assets, timing the market can be a tempting but risky endeavor. Historical data reveals that missing even a handful of the market’s best-performing days can drastically reduce returns. The charts below highlight just how crucial it is to remain invested in both Bitcoin (BTC) and Ethereum (ETH), the two most widely traded digital assets.
For example, for BTC, from January 1st, 2020 to December 31, 2024:
• Missing the top 5 trading days would reduce Bitcoin’s annualized returns from 66.7% to 44.5%.
• Missing the top 25 days would result in a negative return of -2.7%.
ETH tells a similar story:
• Missing the top 5 days reduces annualized returns from 91.7% to 55.7%
• Missing the top 25 days results in a -5.9% annualized loss.
Impact of missing top days on BTC performance
Historical performance in USD*
Annualized returns - Missing top performing days*
Impact of missing top days on ETH performance
Historical performance in USD*
Annualized returns - Missing top performing days*
What’s particularly interesting is how these volatile surges occur unpredictably. Even in a bear market or during extended periods of stagnation, a single piece of positive news can trigger a sharp, upward movement in price. This is where option strategies prove their value. By employing strategies such as selling puts or calls, investors can continue holding the asset while earning premiums, ensuring they maintain exposure without having to worry about perfectly timing the market.
In conclusion, the crypto market’s inherent volatility makes long-term commitment essential for success. Instead of attempting to time the market, investors should focus on strategies that maximize returns while keeping them consistently engaged. The next section explores accumulation techniques designed to help investors earn returns without needing to predict the market’s next move.
Moving beyond passive holdings
The traditional "buy and hold" strategy may serve as a foundation for many portfolios, but it often leaves significant value unrealized. As the digital asset market matures, it increasingly offers parallels to traditional finance, where investors can generate income alongside capital gains. Today’s strategies allow investors to harness the inherent volatility, liquidity, and technological innovation of digital assets to generate yield and optimize portfolio outcomes. Here’s how:
How it works: In Proof of Stake (PoS) networks, staking involves locking digital assets to validate blockchain transactions, earning rewards in return.
- Benefits: Predictable returns (5–10%), network security, low involvement.
- Considerations: Asset illiquidity, market risk, and potential penalties for validator errors.
- Traditional parallel: Comparable to bond-like instruments such as Floating Rate Notes
How it works: Lending strategies involve supplying liquidity to borrowers through centralized or decentralized platforms, offering competitive yields while retaining asset custody.
- Benefits: Higher yields, borrowers collateral, mitigating default risks
- Considerations: Platform security, rehypothecation risks, and dependency on well-audited systems
- Traditional parallel: Comparable to high-yield bonds or private lending
Option strategies in the digital asset space offer investors a powerful dual benefit: the ability to generate yield while strategically accumulating assets at favorable prices. These approaches, centered on selling put and call options on cryptocurrencies like Bitcoin or Ethereum, provide a structured way to earn income and manage market exposure. For long-term holders who believe in the asset class, option strategies are particularly attractive, allowing for increased exposure without the need for constant market monitoring.
How it works
Selling Put Options:
Investors earn premiums by selling put options, which obligate them to buy the underlying asset at a predetermined strike price if the market price falls below that level. This allows investors to accumulate assets during pullbacks at prices they find attractive. If the price remains above the strike, they keep the premium as income without purchasing the asset.
Selling Call Options:
By selling call options, investors earn yield while obligating themselves to sell the asset at a higher strike price if the market rises above it. If the strike price is exceeded, they sell at a profit and keep the premium. If not, the option expires worthless, and they retain both the premium and the asset, effectively managing exposure during rallies.
Key benefits
- Full asset custody: Unlike staking or lending, option strategies allow investors to retain control over their assets. This minimizes counterparty risk and ensures flexibility in managing holdings.
- Flexibility in risk management: Options provide a way to adjust risk exposure dynamically. Investors can set strike prices to align with market expectations, balancing yield generation with the potential to acquire or sell assets at desired levels.
- Capitalizing on volatility: During periods of high market turbulence, option premiums rise, increasing the potential yield for investors. This allows them to turn volatility into an advantage while staying invested.
- Lower risk than high-leverage products: Compared to perpetual swaps or other leveraged instruments, options are less risky, providing a more controlled approach to market participation.
Considerations
- For put sellers, the primary risk is being obligated to buy the asset during sharp price declines, potentially acquiring holdings that may depreciate further in the short term.
- For call sellers, the risk lies in missing additional gains if the asset price surges significantly beyond the strike price.
- Successful execution requires careful management of strike prices, expiration dates, and overall portfolio exposure to mitigate these risks effectively.
A case in point: The Diamond Hands strategy
Diamond Hands is an actively managed options strategy designed to accumulate additional Bitcoin at favorable price levels while generating consistent yield.
By leveraging an accumulation-focused approach, this strategy uses existing BTC holdings to sell options, earning premiums that enhance yield while positioning to acquire more Bitcoin during market pullbacks. This dual-purpose approach allows investors to grow their BTC holdings strategically, aligning with long-term accumulation goals.
Beyond generating yield, the strategy improves both absolute and risk-adjusted returns in USD terms by increasing Bitcoin holdings over time, capitalizing on market volatility to secure assets at advantageous prices.
Key performance metrics (since Jan-2019, net of fees)*
Past 12 months performance: DH BTC vs BTC*
Fund performance metrics (net of fees)*
Simulated performance
Note: Official NAVs are based on the last closing prices on the Valuation Day. *) Performance numbers up until Dec-23 (inclusive) are simulated numbers net of fees. There is no guarantee that market conditions during the past period will be present in the future.
Impact to passive BTC exposure - key metrics (since Jan-2019)**
Historical exposure in USD vs Passive BTC exposure**
Performance metrics based on monthly returns. Calculations involving data points prior to inception are based on simulated numbers net of fees. Source: Google Finance, S&P and company data. *) P&L Contribution analysis for indicative purposes only. Option contributions reflect total payout of the position (i.e., premium received/paid and final payout). **) Performance numbers up until Dec-23 (inclusive) are simulated numbers net of fees. There is no guarantee that market conditions during the past period will be present in the future. ***) Adjusted Maximum Drawdown represents the reduction in drawdown experienced when investing BTC holdings in DH BTC, compared to simply holding BTC passively.
Download the Diamond Hands factsheets (BTC and ETH) to discover how this strategy can help you optimize your Bitcoin holdings and reach your investment goals.
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The full breakdown
In our first article, "Navigating Crypto Volatility: The Advantages of Active Management," we explored how the high volatility and low correlation of digital assets with traditional asset classes create unique opportunities for active managers. We discussed how these characteristics enable active managers to execute tactical trading strategies, capitalizing on short-term price movements and market inefficiencies. Building on that foundation, we now turn our attention to the unique market microstructure of digital assets.
Conducive market microstructure of digital assets
The market microstructure of digital assets - a framework that defines how crypto trades are conducted, including order execution, price formation, and market interactions - sets the stage for active management to thrive. This unique ecosystem, characterized by its continuous trading hours, diverse trading venues, and substantial market liquidity, offers several advantages for active management, providing a fertile ground for sophisticated investment strategies.
24/7/365 market access
One of the defining characteristics of digital asset markets is their continuous, round-the-clock operation.
Unlike traditional financial markets that operate within specific hours, cryptocurrency markets are open 24 hours a day, seven days a week, all year round. This continuous trading capability is particularly advantageous for active managers for several reasons:
- Immediate response to market events: Unlike traditional markets that close after regular trading hours, digital asset markets allow managers to react immediately to breaking news or events that could impact asset prices. For instance, if a significant economic policy change occurs over the weekend, managers can adjust their positions in real-time without waiting for markets to open.
- Managing volatility: Continuous trading provides more opportunities to capitalize on price movements and volatility. Active managers can take advantage of this by implementing strategies such as short-term trading or hedging to mitigate risks and lock in gains whenever market conditions change. For instance, if there’s a sudden drop in the price of Bitcoin, managers can quickly sell their holdings to minimize losses or buy in to capitalize on the lower prices.
Variety of trading venues
The proliferation and variety of trading venues is another crucial element of the digital asset market structure. The extensive landscape of over 200 centralized exchanges (CEX) and more than 500 decentralized exchanges (DEX) offers a wide array of platforms for cryptocurrency trading. This diversity is beneficial for active managers in several ways:
- Risk management and diversification: By spreading trades across various exchanges, active managers can mitigate counterparty risk associated with any single platform. Additionally, the ability to trade on both CEX and DEX platforms allows managers to diversify their strategies, incorporating different levels of decentralization, regulatory environments, and security features.
- Arbitrage opportunities: Different venues often exhibit price discrepancies, presenting arbitrage opportunities. For example, managers can buy an asset on one exchange at a lower price and sell it on another where the price is higher, thus generating risk-free profits.
- Access to diverse liquidity pools: Multiple trading venues provide access to diverse liquidity pools, ensuring that managers can execute large trades without significantly impacting the market price.
Spot and derivatives markets (Variety of instruments)
The seamless integration of spot and derivatives markets within the digital asset space presents a considerable advantage for active managers. With substantial liquidity in both markets, they can implement sophisticated trading strategies and manage risk more effectively.
For instance, as of August 8 2024, Bitcoin (BTC) boasts a daily spot trading volume of $40.44 billion and an open interest in futures of $27.75 billion. Additionally, derivatives such as futures, options, and perpetual contracts enable managers to hedge positions, leverage trades, and employ complex strategies that can amplify returns.
Overall, the benefits for active managers include:
- Hedging and risk management: Derivatives offer a powerful tool for hedging against unfavorable price movements, enabling more efficient risk management. For instance, a manager holding a substantial amount of Bitcoin in the spot market can use Bitcoin futures contracts to safeguard against potential price drops, thereby enhancing risk control.
- Access to leverage: Managers can use derivatives to leverage their positions, amplifying potential returns while maintaining control over risk exposure. For instance, by employing options, a manager can gain exposure to an underlying asset with only a fraction of the capital needed for a direct spot purchase, thereby enabling more capital-efficient investment strategies.
- Strategic flexibility: By integrating spot and derivatives markets, managers can implement sophisticated strategies designed to capitalize on diverse market conditions. For instance, they may engage in volatility selling, where options are sold to generate income from market volatility, regardless of price direction. Additionally, managers can leverage favorable funding rates in perpetual futures markets to enhance yield generation. Basis trading, another strategy, involves taking offsetting positions in spot and futures markets to profit from price differentials, enabling returns that are independent of market movements.
Exploiting market inefficiencies
Digital asset markets, being relatively nascent, are less efficient compared to traditional financial markets. These inefficiencies arise from various factors, including regulatory differences, market segmentation, and varying levels of market maturity. For example:
- Pricing anomalies: Phenomena like the "Kimchi premium," where cryptocurrency prices in South Korea trade at a premium compared to other markets, create arbitrage opportunities. Managers can exploit these by buying assets in one market and selling them in another at a higher price.
- Exploiting mispricings: Active managers can identify and capitalize on mispricings caused by market inefficiencies, using strategies such as statistical arbitrage and mean reversion.
The unique aspects of the digital asset market structure create an exceptionally conducive environment for active management. Continuous trading hours and diverse venues provide the flexibility to react quickly to market changes, ensuring timely execution of trades. The availability of both spot and derivatives markets supports a wide range of sophisticated trading strategies, from hedging to leveraging positions. Market inefficiencies and pricing anomalies offer numerous opportunities for generating alpha, making active management particularly effective in the digital asset space. Furthermore, the ability to hedge and manage risk through derivatives, along with exploiting uncorrelated performance, enhances portfolio resilience and stability.
In our next article, we'll delve into the various techniques active managers employ in the digital asset markets, showcasing real-world use cases.
