AnyHedge Trading Strategy from Fundamentals

BCHBull as a financial instrument has been used in tens of thousands of contracts involving hundreds to thousands of takers, but we have generally assumed "the takers will figure out what's best for themselves". Without a basic breakdown of costs, upsides, downsides in the simplest strategies, only the users most confident about their strategies would participate. Here we attempt to list some of the basic components a taker may be interested in when deciding whether to engage in a trade.

This document is written from the perspective of a trader with his basis in USD, with associated capital costs. We are aware that many BCHBull regulars are "native" users who trade with a basis in BCH, this crowd may have slightly different considerations that will be addressed in a future writeup.

Cost and returns: Base equation

There are three outcomes for the taker in every formed contract:

1. Maturation, where the asset/BCH price does not breach either the upper or lower liquidation limit for the duration of the contract, and it expires returning coins according to terms.
2. Liquidation against taker: Asset price breaches liquidation limit against the taker, aka lower limit if taker is long, and upper limit if taker is short. Contract is cut short, the taker loses 100% of funds in the contract. Premiums and fees paid or received up front are not affected.
3. Liquidation in favor of taker: Asset price breaches liquidation limit in favor of the taker, aka upper limit if taker is long, lower limit if taker is short. Contract is cut short, taker receives 100% of funds in the contract. Premiums and fees paid or received up front are not affected.

The taker should determine the likelihood of each of these outcomes, then consider costs and returns for them separately.

expectedReturn = maturationLikelihood * maturationReturn
                 + liquidationLossLikelihood * 0
                 + liquidationGainLikelihood * liquidationGainReturn

expectedCost = maturationLikelihood * duration * capitalCostPerDuration
             + liquidationLossLikelihood * (fullPrincipal + capitalCostPerDuration * duration * 0.5)
             + liquidationGainLikelihood * (capitalCostPerDuration * duration * 0.5)

Where maturationLikelihood + liquidationLossLikelihood + liquidationGainLikelihood = 1. Assuming chance of liquidation is low at any given point in time, we may assert that if liquidation happens at all, it is equally likely to happen at any point in time over the duration, therefore expected duration if a liquidation happens is half the maturation duration.

While the likelihood of each outcome already constitutes a prediction of sorts, the taker likely has an opinion (alpha) about the likely price movement direction and magnitude without liquidation. So the maturation component can be further broken down into

maturationReturn = alpha * leverage * fullPrincipal - fees - premium

Where alpha is the taker's opinion how much the price could move in his favor if positive, and against him if negative, denominated in a fraction. For example, if the taker is long and he predicts the price to move +5%, then alpha is 0.05. As the maturation component by definition does not account for liquidation scenarios, alpha * leverage * fullPrincipal shall not exceed the counterparty starting contract funds if positive, and shall not exceed fullPrincipal if negative.

Premium and fee are both positive when in *maker*'s favor, thus they only pay the taker if negative.

liquidationGainReturn is the entirety of the counterparty's contract principal.

So the final expected yield is:

expectedYield = expectedReturn / expectedCost

expectedYield =
  (maturationLikelihood * (alpha * leverage * fullPrincipal - fees - premium)
   + liquidationLossLikelihood * 0
   + liquidationGainLikelihood * fullPrincipalCounterparty)
  /
  (maturationLikelihood * duration * capitalCostPerDuration
   + liquidationLossLikelihood * (fullPrincipal + capitalCostPerDuration * duration * 0.5)
   + liquidationGainLikelihood * (capitalCostPerDuration * duration * 0.5))

Strategies: Existing Alpha

If the taker has confidence in:

1. A direction and magnitude of price move over a certain period in time, or
2. Likelihood of liquidation events over the same period in time

Then given known fees, premium and capital cost, the taker can evaluate whether the `expectedYield` above resolves in a positive number, making the contract profitable.

Note that increasing leverage may make a contract profitable via increasing the expected maturationReturn without additional capitalCostPerDuration, but it will also increase liquidationLikelihood in both directions. As in most other markets, high leverage generally fares better as a strategy in low volatility markets.

Strategies: Hunting Premiums within BCH Bull

Sometimes the taker would want to make two contracts that resolves to neutral over certain conditions in order to get a net yield on premiums, which can sometimes be negative (the LP pays the taker). Generally BCHBull does not give net negative premiums for two contracts that *exactly* mirror each other, so some compromising assumptions need to be made.

One example is entering two contracts, one short and one long, that mirror each other on all parameters except for duration. The taker makes an assumption that asset price will not change significantly, or change in his favor, between maturation of one contract to maturation of another. From the base equation, premium1 + premium2 + fees1 + fees2 of the two contracts need to resolve to negative as a prerequisite, for the easiest case where alpha is expected to be small.

Strategies: Combining with External Positions

Sometimes a taker does not only consider positions within BCH Bull, he must also consider his external positions. Whichever instruments he use outside of BCHBull, as long as it's based on asset prices, he would likely have the same alpha as well, as well as similar capitalCostPerDuration. So it should be possible to calculate if expectedYieldBCHBull + expectedYieldExternal resolves to positive over a given duration.

Early Settlement Considerations

For the purpose of this documentation, we do not consider Early Settlement, a contract exit option with different fee and permissions enabled on the current BCHBull setup. It is generally useful to simply treat Early Settlement as forming a new contract with mirror parameters as the remaining contract such that they add up to neutral on the taker's asset basis, but this ignores the fact that using Early Settlement incurs less capital costs than forming a mirror contract.

If you want to test a trade in a safe way start with the AnyHedge calculator inside the simulation page.