The current price fluctuation in ADA has generated much concern and a state of helplessness among my colleagues at Catalyst and the community at large in the face of the loss of value of their funded proposal budgets.
The purpose of this article is to present from an Efficient Market Theory* point of view, simple arguments that can provide project managers and proposal executing teams with a better view of the current developments in the field of price oscillation in the market in general, and in the cryptocurrency sector in particular, promising from the start that this will not be the first nor the last time a similar situation will take place.
Intentional ignorance or natural aversion to certain types of knowledge is disregarded for the consequences when they show up in our lives and sabotage our well-intentioned creative efforts. Situations such as those we are currently experiencing as project implementers at the level of price volatility, where we feel a complete loss of control, call for us to begin to educate ourselves financially and give budget management its position as a key element in designing our proposals.
Volatility, the driving force behind the aggressive price movements, is just that: a force of nature. And it is a force of nature because it arises from the millions of human interactions that occur at the market level every day. It's not just greed, or ambition, or big fish eating little fish, or a bunch of little fish wanting to be a big fish: it's all of those things at once, with the random dynamics that those situations create.
Market dynamics are random. There is no economic model on the planet, not even the ones that are financed with the money that can buy the best talent, the best technology, the best friends, that is able to efficiently predict what the market is going to do in the short and long term. Completely unpredictable in my opinion. However, unpredictability is not synonymous with opacity: market dynamics are available to anyone who wants to study and understand them beyond the popular "buy low and sell high", beyond the possible predation and advantage of a few, so famous in the 80's but reduced today (more than those few would like to recognize) in today's liquid, dynamic and efficient markets.
In today's liquid markets, opportunities for manipulation are rare. Professionals and institutional money still exist, and of course, their motivations remain the same. However, a cryptocurrency market of over a decade of legitimate existence despite multiple attempts at dismissal and demise (with a market cap approaching $3 trillion USD last year, $1.5 trillion this week) is evidence enough of the difficult conditions in which the Buffets, Dalios, Diamons, Roubinis, Ackmans, Bernankes, Yellens or Powells of the world find themselves when it comes to navigating with the old playbook a changing, efficient and constantly moving market like the current one.
Prices move. This is a fundamental truth. They move, at times, to the point of eliminating companies and disappearing investments. A complete depuration process so similar to that which occurs in other natural systems that it would be unfair not to give the benefit of the doubt to the possible occurrence of a virtuous circle of elimination of excesses, intolerable for bad companies and imprudent investments.
Markets move, things change. The following should be known about price fluctuations:
Prices move, but they do not do so perpetually in one direction only: they stop their movement, enter in an erratic directionless state, or sometimes simply take the opposite direction.
Although it may not seem so, 95% of price movements (2 Standard Deviations) are covered by a probability distribution:
The remaining 5% (> 2SD) is made up of outcomes that cannot be predicted, extreme movements outside of any mathematical model. They tend to do the most damage in situations of improper accumulation of risk. This 5% is known as Tail Risk.
What makes the probability distribution relevant is the fact that it is the template used by the so-called market makers to set the prices that in the form of a premium will be paid by the buyers of financial derivatives (options) and charged by the sellers of those derivatives: the buyers buy from the sellers the right to hedge their risk of loss in the face of an unexpected event (such as the current market crash, in which everything falls at once), the sellers charge for giving the buyers that right. The spread between bid and ask prices is where the profit of these market makers arises, which accumulates daily by billions of dollars through the occurrence of millions of daily transactions. Therefore, it can be concluded that the gigantic amounts of money that cutting-edge technology organizations such as Virtu, Two Sigma or Citadel generate on a daily basis must necessarily be backed up in models with the best brains and the best technology on the planet behind them.
Remark: of course, the unbiased normal distribution shown above is almost a cliché. In the reality of markets it is usual to find distributions whose probabilities are more skewed to one side than the other, i.e., where one thing is more likely to occur than the other:
Image: Skew normal distribution. Wikipedia(https://en.wikipedia.org/wiki/File:Skew_normal_densities.svg)
This situation is immediately reflected in the prices of derivatives, as can be seen in the following example:
Image via tastyworks.com
This stock, close to $560 usd in the public market, assigns different prices (different premium) to derivatives that are at equal distance from the $560 usd mark: $20 usd down the price of the derivative is $7.65 usd, $20 usd up the price is $6.35 usd. The price difference in the derivative premiums, at equal distance, indicates that the stock is more likely to go to $540 than to $580. If a review is made of the prices of the derivatives at greater distances on either side of the $560 usd mark, it is possible to conceive the shape of the probability distribution of the prices of that particular stock. In addition, it is possible to establish with a good probabilistic certainty (1SD) what the range of price movement will be over a specific time period (+-$33 usd in 23 days, see orange boxes at the top of the image).
Two are the invitations I make through this article:
Do not base your conclusions on the information provided by the news: it is a useless and exhausting exercise. The "talking heads" in the news and the bombastic internet headlines are only delayed indicators of scenarios that are already baked into prices. There is not a drop of future in them and a lot of noise with an agenda behind it. If this were not the case, the cryptocurrency industry would have disappeared more than a hundred times over by now.
When you get your budget badge, you are faced with three paths, or three gates as in the Monty Hall problem: the ADA price stays in a stable range (about 1:1 with the usd), the ADA price rises well above the stable range (in which we all pop open the champagne to celebrate), the price falls well below the stable range (in which we must cut wages, delay payments, reduce the quality of our product, and start blaming the market and the fat cats as a relief medicine). Two of those doors are the way to paradise (in them the concentration on creative work remains undisturbed and at a peak level), while the occurrence of one of them means a punch right in the face (we start to distribute our concentration between the not-so-creative work and the noise of financial news headlines).
Faced with this situation, with your proposal's budget badge in one hand and a lottery ticket with a 68% probability in favor (1 Standard Deviation - see "Standard Deviation in Options" graph above) in the other, you must make the visceral effort to remind yourself that, above all else, from that moment on, you are a project manager and not a speculator. Therefore, you must look for ways to protect the value of your project budget by giving up price hikes altogether in exchange for protection against price drops. One such way is based on the use of stablecoins such as Djed whose algorithmic design uses smart contracts to ensure price stability.
Remember: as a manager of a funded proposal you can hedge the risk on your budget 95% of the time, because robust mathematical models (best talent, best technology) account for 95% of everything that is possible. The remaining 5% does not happen often (only 5% of the time). However, when it does occur, it is usually an existential threat unknown in magnitude and duration to any funded project or proposal that has not taken the appropriate steps from the very beginning to protect the value of its financial resources. Conversely, those teams that from the start have foregone speculative price spikes in exchange for protection against market downturns (that unknown 5% whose effect drives the price of everything down with no place to hide), are in a better position to withstand the blows of market randomness and survive to fight another day.
(*) In general terms, the Efficient Market Theory refers to the fact that all known information is reflected in the price at any point in time. While it is true that there is never a shortage of financial theories, it could be said that this theory in particular has important similarities with Cardano: it is in the top five list of the most important ones and has proven itself after surviving violent financial wars: the Black Monday of 1987, the Asian financial crisis of 1997, the collapse of Long-Term Capital Management L.P. (LTCM) in 1998, the dot-com bubble of 2000, the crash of 2008, the flash crash of 2010, the market crash of 2020, among others.
This article is based on the insights of veteran floor traders, with over 40-year careers to date, who began putting it into practice on the sweaty, noisy floor of the Chicago Board Options Exchange (CBOE) and watched it evolve into the digital world. To them, Tom Sosnoff and Tony Batista (www.tastytrade.com), my thanks for providing me with the missing piece (actually, the whole puzzle) in understanding market dynamics after more than 12 years of study. Footnote: Tom Sosnoff interviewed Charles (Hoskinson) in August 2021 . Many themes in common with Charles.