Why HODL When You Can Follow Trend?
HODL is a meme term that was born out of the Bitcoin craze back in 2013. What started as a typo became an acronym for "hold on for dear life". It quickly became a mantra among crypto enthusiasts to buy and hold cryptocurrencies for the long term. This is not unlike the mantra among stock enthusiasts to buy and hold stocks to benefit from the tendency of the stock market to go up in the long run. However, as our students who learned about our trend-following philosophy know, buy and hold may not be the ideal approach to harvest the long-term growth of the stock markets. So does it also mean that trend-following is also a better approach than HODL in the crypto world? To answer this question, I decided to apply the trend-following strategy that we teach on a basket of cryptocurrencies and compare the historical performance of trend-following versus HODL.
Before I perform the backtest, I need to set some of the parameters to be used in the simulation. First of all, what should the trading cost be? I have no experience trading cryptocurrencies so I do not have a sense of what the trading cost is like so I just used a conservative trading cost of 2% for each trade. In any case, the trading cost for trend-following is not so critical because the trading frequency is relatively low. The next question is what leverage should I use? Cryptocurrencies are notoriously volatile and I generally do not like to trade a volatile underlying on full size. So I decided to use a leverage factor of 0.4. This means that for every $1000, I'm only going to deploy $400 into the strategy. Naturally, this would mean an underperformance compared to HODL during a strong uptrend. Because there is no leverage employed, there is no need to factor in borrowing costs.
One of the key requirements for trend-following is diversification and so I need to have a portfolio of cryptocurrencies to apply trend-following on. Naturally, I would want to populate the universe with cryptocurrencies that have price data going back as far as possible. To that end, I arrived at the universe below.
HODL generated almost twice as much return as trend-following over the entire simulation period. But considering that trend-following only used 0.4x leverage, trend-following was more efficient in generating returns. In terms of CAGR, trend-following generated 30.6% which is not too shabby compared to 42% for HODL. Where trend-following wins over HODL is in reducing risk. The annualized volatility of trend-following is almost half that of HODL. This leads to a higher Sharpe ratio or risk-adjusted return for trend-following. In terms of maximum drawdown, trend-following was unable to avoid a significant drawdown of 72% but this is still better than a jaw-dropping 94% experienced by HODLers.
Retention of Bubble Profits
It is clear from the chart above that cryptocurrencies went through two boom-bust periods, once from 2017 to 2018 and the most recent one from 2020 till now. This is where the main advantage of trend-following is apparent. Trend-following can participate in the uptrend of a bubble and retain the bulk of the profits before the bubble burst completely. For the most recent bubble, trend-following has already exited all the cryptocurrencies except Namecoin. If this proves to be the end of cryptocurrencies, trend-following is fine as the profits have already been locked in. If this proves to be just another crypto winter whereby cryptocurrencies can restart another bubble, trend-following will be prepared to participate in the next bubble. Meanwhile, HODLers are entirely dependent on the ultimate fate of cryptocurrencies.
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