Crypto traders and investors are not strangers to market volatility. After all, long-term investors refer to themselves as Hold On for Dear Lifers (HODLrs) for a reason. While many crypto investors have been handsomely rewarded over the long term, there have been plenty of bumps in the road, including the recent ~40% drop in Bitcoin.
Let's take a look at how crypto assets act in bear markets and strategies to hedge your portfolio.
Bear markets are a common occurrence in the crypto space—here's how investors can avoid losing money.
What is a Bear Market?
A conventional bear market occurs when the stock market drops by 20% or more from recent highs—although crypto markets may need a higher figure to account for their greater volatility. These conditions occur when the supply exceeds demand and prices move lower to reach equilibrium. and pessimistic traders are often referred to as "bears."
Bear markets are a double-edged sword. On one hand, those that lose confidence and sell often experience losses. On the other hand, panic selling often enables long-term investors to buy at a discount. And, short-term traders may be able to make quick gains when the market rebounds—although predicting these rebounds is notoriously difficult.
Should You Sell Your Holdings?
Many investors sell assets when there's a bear market to avoid experiencing further losses. But, of course, these investors need to time their re-entry into the market to be successful. Several studies have shown that humans are notoriously bad at market timing—or buying and selling at the right times to turn a profit.
For example, between 1930 and 2020, buy-and-hold investors would have made a 17,715% return. However, missing just the best ten days of each decade lowers that return to just 28%. Many of these strong days come during the depths of a bear market when investor pessimism is at a high—and most people are tempted to stay in cash.
In addition to holding onto existing assets, investors that continue investing during a bear market benefit from dollar-cost averaging—or lowering their overall cost basis during market downturns. By buying during a bear market, you can help offset the high prices paid during a bull market to lower your average buy price, or cost basis.
Short-term traders that want to capitalize on a bear market can also look toward technical analysis to pinpoint potential turnaround points. For instance, you can look for a reverse “head and shoulders” pattern or a bullish engulfing to identify a potential turnaround. However, technical analysis can be difficult to learn and execute.
How to Hedge Against Losses
Dollar-cost averaging is an example of a hedging strategy. In essence, you're continuously buying an asset to hedge against price volatility. The most common dollar-cost averaging strategy is setting up an automatic monthly investment that occurs on a set day each month. That way, you're not trying to time the market and always remain in the market.
Yield farming and staking can also help hedge a crypto portfolio against losses. For example, you might hold a portion of your portfolio in stablecoins and capitalize on yield farming opportunities instead of holding speculative tokens. Curve Finance, Pancake Swap, Uniswap, and other DeFi protocols make it easy to participate in these activities.
Of course, long-term investors should also maintain a diversified portfolio containing non-crypto assets. If there’s a downturn in the crypto market, these other assets can help provide stability and protect their larger nest egg. In fact, Vanguard points out that 88% of volatility in a diversified portfolio comes from asset allocation rather than choosing specific investments.
Finally, many crypto market downturns arise from smart contract vulnerabilities or theft. As a result, you may want to consider purchasing insurance as a way to hedge against these risks. Nexus Mutual provides a Protocol Cover program that covers against these losses. However, you should take into account the impact on returns before buying insurance.
Tax-Efficient Bear Market Strategies
Bear markets inevitably lead to losses for those that remain in the market. But fortunately, there are some strategies that you can use to take advantage of the decline to offset your tax liabilities. That way, you can save money on your taxes at the end of the year and even reduce your overall income taxes by up to $3,000.
Tax-loss harvesting is the most popular technique. The strategy involves selling crypto assets to realize a loss in the current tax year and then repurchasing them to maintain your asset allocation. In essence, you're deferring your capital gains taxes until later and potentially capitalizing on temporary losses in the meantime.
Of course, there are some limitations to keep in mind. While tax-loss harvesting is still legal in the crypto space, there's a distinct possibility that new regulations will impose the same limits facing stock market investors. The "wash sale rule" would prevent you from repurchasing an asset within 30 days and still realizing the tax loss.
The Bottom Line
Crypto traders and investors are familiar with bear markets, and most HODL for the long term. According to a growing body of research, investors shouldn't try to time the market by selling during a bear market and trying to buy at the bottom. Instead, dollar-cost averaging along with a hedging strategy can help reduce risk and maximize long-term rewards.
At the same time, investors should be mindful of their tax situation. Investors that sell short-term holdings during a bear market could be on the hook for costly short-term capital gains taxes, while realizing temporary losses can help lock in tax savings. These little tax saving tips can help dramatically improve long-term performance.
If you trade cryptocurrencies, ZenLedger can help you keep everything organized for tax season. In addition, we provide tax-loss harvesting tools that you can use to take advantage of bear markets to minimize your taxes each year.