Mitigating Inventory Losses by Predicting Volatility.
My data-driven research on moments where higher volatility is statistically significant and how I react as a Market Maker.
What is Volatility and Why is it Bad?
Volatility is when there is suddenly a huge amount of buys or sells interest. A good illustration would be these.
For liquidity miners who are mining rewards on Hummingbot, this is terrible news. Why? Because a common strategy that we aim for is to have as little trades as possible while maintaining as low a spread as possible. That’s when we have the least amount of losses on our trades, all while having a surplus on the rewards end.
I have experienced - and I’m sure you would have if you’re a liquidity miner - where I had a whole week of earned rewards in the 5-10% ROI, just to have it wiped away in 10 minutes due to a sudden market shift.
So, how then do we predict when times might be volatile?
Evading the whales
Whales are the arch-nemesis of market makers. Why? Cause they’re the ones who cause all these shocking pumps and dumps. Coming in and buying or selling $1 million worth of coins on market rates, sweeping up the order books on one side and causing a permanent shift in the middle prices. As market makers, our bots tend to have bids and asks near the mid prices. Imagine setting a bid at $99 for a $100 mid price coin, and a whale sweeps in and takes all orders till it’s $80. You as a market maker bought his coins at $99, and now the prices are set at $80 for the near future. If you sell the coins anywhere below $99, you have just realized a loss in the 10-20%.
Logically then, we don’t want to market make when the whales are active. Or at the very least, increase our spreads so that we don’t suffer as terrible a loss.
What I’ve discovered
I retrieved the past five years of hourly and daily crypto prices for BTC and ETH and tried to investigate which hours and days tend to have the most significant price changes (close - open). Knowing when price changes are statistically more likely to happen would help us evade market-making during these hours.
As seen below, I discovered that UTC 0000, 0800, 1200 are the times when price change happens the most. Coincidentally, these are the times when the HKSE (0000), LSE (0800), NYSE (1200) are just about to open.
Furthermore, when it comes to which day prices change the most, I discovered that price changes happen most on Mondays (0 in the chart below) and Wednesdays.
You can verify it by going on your market pairs, and looking at the most obvious price changes and volumes in hourly tickers. Look at the sudden increase in volume traded, and how it causes the market to be significantly more volatile and sudden in it’s movements.
Thus, it seems logical to infer that Hedge Funds (or certain corporates who correlatedly trade the traditional market at the same time) are one of the most significant trading whales in the cryptocurrency market. And we should take evasive market-making measures during these hours on Monday & Wednesday.
But of course, my current research shows that this only applies to crypto with a large market cap (BTC, ETH, ADA, etc). Smaller Altcoins might not obey these exact hours, as it’s mostly held by whales or initial investors, but there might be specific patterns you can infer from the charts as well. Go over the charts, and look for the times when there are the most significant dips and rises; try to see if it happens at the same time every time, or maybe a particular day, or a particular event. Look for a pattern.
Granted, here’s the thing. Don’t market make too much on new projects or cryptos without extensive due diligence on the project (If you’ve mined DIVI, xDai, OMI, ASD, you know what I’m talking about). After all, if, in the worst-case scenario, it is a pump and dump scheme, we as market makers don’t want to be left holding a bag of worthless coin dumped by a whale. If you are still interested in taking up the challenge, maybe operate it on a small part of your portfolio instead of dropping all you have into it.
What should we do then?
I am not providing personalized investment advice, and I am not a qualified licensed investment advisor. The content is for informational purposes only, and you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Seek a duly licensed professional for investment advice. Furthermore, I am in no way affiliated with Hummingbot. Thus, all I write is non-representative of Hummingbot’s view. By applying any of the information here in your trades, you agree that you are fully responsible for the results of your application.
For me, I wrote a script that works in conjunction with the Pure Market Making Strategy. Where I pre-coded certain hours in UTC that I want my bot to evade, and during those hours, depending on the pair, I either set buy and sell levels to 0 or triple my spreads so as to be safer. You can try and tweak it on your own, your mileage might vary, but it has certainly helped me.
If you can’t code or would like a copy of my script, you can DM me on Discord through here and I’ll send one on your way.
Read more!
If you liked this piece, I’ll appreciate any feedback on my writing or further discourse on my research above.
Also, I wrote more pieces on my research into optimizing and mitigating risk on Market Making. Read them below!