Lessons Learned From a Grizzly Bear Market
How You Can Protect Your Gains and Survive
The 2022 Bear market has been brutal for assets across the entire risk spectrum, but particularly agonizing for digital assets. Cryptocurrency traders are familiar with volatility, but the 74.4% drop in total market cap just over 6 months has been extremely dramatic.
The combination of high inflation, a hawkish Federal Reserve, systemic risk within centralized lenders and over-leveraged cryptocurrency actors, and myriad of other factors compounded the ferocity of the market selloff following the 2021 Bull.
“Making it” (being successful and generating outsized returns) in cryptocurrency trading is all about survival. The bitcoin halving cycles change each time as exchanges evolve, new tokens emerge, and teams innovate with experimental protocols. Each bubble continues to get bigger and bigger and can entice investors to believe there is no stopping the technology, and no top to the price chart.
This article summarizes our 14 lessons learned throughout the late 2021-2022 bear market (besides the obvious - “Don’t Fight the Fed”).
Lesson 1 - We can no longer trust CeFi
The fourth largest cryptocurrency exchange, FTX, lead by Sam Bankman-Fried, is in need of a bailout from Binance to fill a multiple billion dollar hole. This is shocking for the industry and will have widespread effects for custodians, traders, funds, and investors.
The number of trustworthy centralized exchanges that have their customer’s best interests in mind is dwindling by the day. Voyager, Genesis, Celsius, Arrakis, and others loaned over $3billion collectively to 3 Arrows Capital, a hedge fund that made extremely unwise investments in risky and illiquid assets. When 3AC went bankrupt, the lenders and their customers were left in ruins. The customer has no power in where their crypto goes, therefore it’s become riskier to have your funds custodied rather than holding your assets on a personal wallet or in smart contracts.
These centralized lenders lack transparency and will get regulatory hammer first. The entire purpose of Bitcoin and cryptocurrency is to introduce greater transparency in the financial system, so we should all keep that in mind for future technological development.
Remember, “NOT YOUR KEYS, NOT YOUR CRYPTO” rings more true than ever in 2022.
Lesson 2 - Capital preservation let’s you live to trade another day
Take (and keep) profits! Crypto is probably the most volatile asset with the largest market ever, and speculators love to take advantage of the ups and downs. Crypto market cycles are also very reflexive, meaning the rises and falls are dramatic and trend in the same direction for a long time.
For crypto natives, product developments, protocol innovations, and new primitives that increase efficiency can have no impact on price and even be bearish depending on the macro conditions. This is a function of the speculative nature of cryptocurrency, and a relatively underdeveloped and unknown fundamental valuation framework. In Bear markets, it’s ok to take some risk. However, it’s very important even when you find a project with good narrative and fundamental growth to take profits earlier than bull conditions. This has been +EV when liquidity and participants wane.
Lesson 3 - Continuously re-evaluate your biases
In cryptocurrency, it’s very easy to support our close network of Web3 friends and colleagues by investing in their protocols’ tokens due to the higher volume of information. A lot of the time that is just noise and what really matters for token prices are flows. Flows often follow investment narratives, which follow fundamental growth metrics, tokenomics improvements, product upgrades, or easier liquidity conditions.
A good example of potential investment bias is Cosmos app chain tokens. Cosmos chains are Delegated Proof of Stake and most tokens have quite high emissions to pay staking yield. The majority of these coins are sold in bearish market conditions, which can crater the price.
Disruption is constant in open source software development, which makes our favorite blue chip or DeFi 2.0 protocol easy to vampire attack or fork. In crypto capital is not loyal so it’s best to keep an open mind to always experimenting and reading about new protocols.
Lesson 4 - Don’t blindly bet on Investment theses without clear PMF
Web3 Social and Gaming were very heavily invested in by venture capital last year and into 2022. Tokens were launched before most of the games were live as a fundraising mechanism, and token prices reflexively soared as the gaming narratives spread across the cryptosphere. Those same tokens crashed the hardest in the bear market as there is still a wide gap between product market fit (adoption) and valuations.
Inversely, projects like GMX have seen consistent fundamental growth (new users, higher revenues, higher volumes) and PMF in the decentralized perpetual trading vertical, and the token has outperformed in the bear market. Decentralized Exchanges will continue to pull in liquidity as users no longer trust their funds with centralized parties.
A good litmus test for our team is to always try out a protocol before investing in it. Do you find it to be valuable, is the UX good, can they easily attract other users, and is the community active/engaged? Some basic due diligence beyond the usual can go a long way.
Lesson 5 - Don’t be afraid to dial back your portfolio
In an environment where risk assets are highly correlated, moving a broad portfolio of bets into a few high conviction plays usually will save your portfolio from big losses.
Bitcoin price trends have historically been a good indicators of where alt coin prices go, as alts have a higher beta to BTC. The 20, 50, and 100-week moving averages or major price levels on daily or weekly timeframes can be a good guide for when to cut or consolidate your alt token holdings.
The bags that are easiest to hold through a bad bear market are the ones you have the highest conviction in.
Lesson 6 - Regulatory risk is very difficult to trade without clarity FUD
Regulatory risk is #1 in most DeFi funds’ lists of known unknowns. A statement by the SEC or a congressperson is sometimes FUD, sometimes legitimate criticism, and always leads to volatility on low time frames. But the risk of cryptocurrency becoming illegal or inaccessible are wildly overstated. Both the SEC and CFTC have been jockeying for jurisdiction, made conflicting statements about how to regulate tokens, and are likely years away from any formal policy. As traders and fund managers, it isn’t our job to judge what’s real and fake, rather we can only make decisions based on published and accepted legislation.
Positive regulations are likely coming for stablecoins, which are essential for the proliferation of decentralized finance and achieving the goals of more efficient capital transfers. A hotly debated bill is being negotiated by the House Financial Services Committee, but should lead to a constructive way forward for stablecoins to merge with the legacy financial system.
Lesson 7 - A stablecoin is not without risk of losing $1 peg
The poster child for this in the 2022 bear market has been $UST. UST was a resounding success story if you looked at its growth. The dollar pegged stablecoin reached a circulating market cap of $18b as depositors piled money into Anchor Protocol and earned 19% yield. Sadly, once withdrawals started to occur, the algorithmic dynamic between minting new LUNA and allowing redemptions for $1 did not keep pace and $UST essentially went to zero.
In the world of DeFi, there are three kinds of stablecoins, and they are not the same.
Centralized stablecoins are backed by treasuries, commercial paper (dollars), and other assets, and are only exposed to the underlying risk of the dollar currency.
Overcollateralized stablecoins are decentralized and backed by cryptoassets. These are minted or borrowed by depositing collateral into protocols like MakerDAO (DAI) or Liquity (LUSD).
Algorithmic stablecoins are usually undercollateralized and require a forcing mechanism (buy backs, burns, dynamic interest rates, e.g.) to rescue the token should it fall below $1. These are the riskiest and $UST fell into this category costing people tremendous sums of money, and is probably the most devastating thing to happen to cryptocurrency since the Mt. Gox Bitcoin hack. (This was written before the FTX/Alameda debacle).
UST also was incorporated into many new DeFi protocols on the Terra blockchain. Teams were incentivizing users to deposit UST in exchange for native protocol tokens, a mechanism called a “Lock Drop.” Sadly, UST was unrecoverable from many new, promising projects on Terra once the depeg event happened.
Bonding also is a popular way for DeFi protocols to build TVL. Bonded liquidity is locked or staked for weeks before it can be withdrawn and prevented users from withdrawing their UST to swap for less risky stablecoins.
The key takeaway is while stablecoin yields are enticing in DeFi, it’s oftentimes safer to hold low risk stablecoins in a secure wallet because it prevents users from losing money due to protocol or mechanism design risk.
Risky stablecoins could have a place in the portfolio, but smaller allocations and diversifying assets across many protocols reduces downside risk significantly.
Lesson 8 - Use Perpetuals and Put Options for hedges, not because we’re bears
We are all crypto believers over the long term and have developed fundamental investment these in products that are enjoyable to use, have enormous TAMs, and we can contribute to personally due to decentralization. We are bullish over a long time horizon.
However, in cyclical downturns it can be very wise to hedge your portfolio in order to protect profits. It can also be far less expensive than selling tokens and paying capital gains taxes.
Low leverage short positions and put options are finding PMF in DeFi and have seen some of the biggest growth in the bear market (GMX, Gains Dopex, and Premia). This is an extremely welcome sign for protecting profits and developing low risk, delta neutral yield strategies too. Arbitrum has been the best ecosytem for structured products this bear market.
Lesson 9 - Use alpha information to your advantage but think like a trader
There are information asymmetries in cryptocurrency due to the way teams communicate. Everything is transparent and can be found through Github commits, Discord/Telegram chats, and Twitter. First movers on bullish or bearish information can reap the spoils to make money in any market conditions.
In bear markets, liquidity and the number of participants diminishes. This environment is often referred to as PvP (Player vs Player) because it could be just you and one or a handful of other traders. The traders that act quickly can catch the move first and take profits before others catch on.
Another observation is that staking/locking tokens for yield can be -EV on short timeframes. It’s better to trade a short term narrative and take profits than lock capital for weeks or months of bearish conditions.
Lesson 10 - Observe other opinions and advice but DYOR and form your own opinions
There is information overload in cryptocurrency investing, and while Twitter analysts can be a tremendous source of alpha, you must make your own conclusions to prevent poor capital management. Most of the tweets read are written by bag holders looking for new capital to sell their tokens to. Even if you agree with the source, always check the price chart before investing. 9/10 times the token will have pumped 50% or more and there will be a better opportunity for patient investors.
Otherwise you will just be exit liquidity. Passing on an exciting token that you read about is likely going to be a -EV move in a bear market.
More importantly, it’s always more rewarding to develop conviction in an investment through your own research and experience than copy trading others. It’s also much less agonizing when your thesis is invalidated because you cannot blame someone else! Accountability is part of the crypto ethos.
Lesson 11 - Trade on high time frames
Cryptocurrency has largely been a price trend following investment with bull and bear markets following the Bitcoin halving cycle. The investors that have respected this cycle have been able to catch the meat of a move up, cash out at a reasonably high multiple, and patiently wait for an attractive price (near 200w moving average) to buy back. While it’s never easy to spot a top or bottom, using high time frame indicators (weekly) can help spot an obvious trend change. Observing weekly trends can prevent investors from holding too long, catching falling knives, and protects capital for the next cycle.
When is a good time to reinvest? The smart money usually starts to DCA when things are dire (price falls below or meets the 200w moving ave).
Lesson 12 - “If you don’t know where the yield is coming from, you are the yield”
This is a common phrase read across articles and crypto twitter, but what does it really mean, and what are some practical examples of this?
Some key variables to consider when yield farming are:
Token float (how large is the circulating supply available for purchase)
Emissions curves - The earliest buyers of available tokens can become liquidity providers and gain a large portion of token rewards. In addition, new buyers and farmers pump the price for a beautiful flywheel.
Once the emissions really crank up, what matters for token price is “flows” - Is more money going in or coming out of the farm? In DeFi, we have short attention spans, so it’s usually difficult for new buyers to add more capital to a new token than the amount of supply getting released after a few days or weeks.
We’re encouraged about the shift from ‘valueless governance tokens’ (brrrr liquidity mining) to ‘real yield,’ as this provides sustainable economics for DeFi protocols.
Lesson 13 - Leverage is mostly a bad idea
Here’s a tip on how to survive in crypto: Do NOT buy risky assets on leverage! In a bear market this can be very costly for two big reasons. Firstly, your collateral can depreciate in value which puts your loan at risk of liquidation (assuming the loan is in stablecoins), and secondly, the asset you purchase is also at risk of losing its value in a bear market.
Leverage can be effective when one is trying to hedge downside risk (it is more capital efficient) or for a personal favorite strategy, stablecoin yield farming. But always watch your collateralization ratio!
Lesson 14 - Have a plan
If you’re a speculator and like to trade market cycles, you must know your all in price and all out price both on the upside and downside. This obviously helps protect gains and prevent paper losses. This is obviously very individual depending who the participant is too.
Know your investment horizon when you go into a trade. If you’re looking to make money in a crypto bull market, protecting profits with hedges can help sleep at night! A long only fund will pay more attention to fundamental metrics than price, and use bear markets as opportunities to increase position sizes.
And finally, never invest more than you’re willing to lose. This is especially true for cryptocurrency where intrinsic and external risks are very high.
Now that we’re equipped with this bear market survival toolkit, wen bull? The next Bitcoin halving occurs in March, 2024 and this event has historically been a good time to invest ahead of. Developers and investors continue to flock and join the Web3 revolution building trustless and permission protocols that save costs and time for users.
Our strategy is to continue to dollar cost average (buy the dips) with our stablecoins and convert yield into ETH (or BTC if that’s your preference) and wait out the bear in the anticipation of a new bull market for the world’s greatest financial innovation!
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