Cryptocurrency markets are extremely volatile. Even the most mature cryptocurrency, Bitcoin, has an annualized volatility in excess of 70% and many crypto tokens exceed 150%. These price swings naturally make some investors wary. There is, however, a strategy which directly targets volatility as its key ingredient to generate excess returns. It is called volatility harvesting.
The idea of volatility harvesting is decades old. Any volatile asset can be volatility harvested — equities, EM currencies, cryptocurrencies and even coin tosses. An asset might start the year at $100, end at $200 and zigzag throughout. A buy-and-hold strategy will gain $100. A good volatility harvesting strategy utilizes the ups and downs to juice higher returns.
The basic premise is that a portfolio consisting of cash and volatile assets, each set at predetermined weights, is repeatedly rebalanced to keep those weights constant. This approach tends to produce additional returns compared to a buy-and-hold strategy. The mathematical underpinnings show that the higher the realized volatility in the market, and the higher the decorrelation between assets, the higher the additional return generated by volatility harvesting.
A volatility harvesting trade
Imagine a portfolio consisting of $100 in Bitcoin and $100 cash. Let’s compare a buy-and-hold strategy versus volatility harvesting. In this example, the price of Bitcoin drops 50% after one period and then recovers 100% after a second period, back to its original starting price.
- Buy-and-hold: The value of the portfolio starts at $200, drops to $150 (when the price of Bitcoin drops 50%) and then rises back to $200 (when Bitcoin prices recovers). This round-trip yields the portfolio 0% return.
- Volatility Harvesting: The value of the portfolio starts at $200 and then drops to $150 (when Bitcoin’s price drops 50%). The portfolio then is rebalanced to hold 50% Bitcoin ($75) and 50% cash ($75). Then, when the price of Bitcoin recovers, the overall value of the portfolio rises to $225 for an overall gain of $25 or 12.5%.
In the volatility harvesting approach, additional returns were produced by rebalancing cash into Bitcoin at the lower price, thus amplifying the portfolio’s gain when Bitcoin recovers. Rebalancing created growth out of ‘no growth’ and in doing so harvested an additional return from volatility.
This is, of course, a very simplified example. Volatility harvesting is complex. It typically happens across a large number of coins with carefully calibrated rebalancing levels and occurs at high speed.
How to implement volatility harvesting
The key to translating the math into profits is implementation through the right algorithm. An ideal algorithm is programmed with the correct rules and rebalancing levels and can trade the market at a fairly high frequency.
For example, imagine a conservative portfolio that is made up of 50 coins in total accounting for just 10-12% of the portfolio by net asset value (NAV). Each coin is assigned a small individual “base weight.”
When an individual coin price moves up or down by a predefined threshold amount, the profit is sold down, or the loss is filled in. This brings the coin back to its base weight. For example, Bitcoin’s threshold might be 3%. If the Bitcoin price rises 3%, the 3% profit is sold down. If Bitcoin drops 3%, that loss is “filled in” through the purchase of additional Bitcoin.
The higher the price volatility for a given asset, the higher the chance it will be fractionally sold down at a higher price and fractionally bought up at a lower price, thereby constantly “buying low and selling high.”
Cryptocurrencies are the most ideal asset market to implement volatility harvesting and generate excess returns in a systematic way given the extreme volatile and decorrelation benefits. This is achievable without being reliant on picking winners and losers or trying to forecast future prices.
Dr. Magnus Holm and Dr. Niclas Sandström together programmed the volatility harvesting algorithm in 2016, founded Hilbert Group in 2018 and listed it on the NASDAQ First North Growth Market in 2021. Hilbert’s primary activity is asset management of algorithmic trading strategies, enhanced by investments in blockchain technologies and incubation of trading strategies incorporating proprietary market data and on-chain analytics.
