In today’s TA Tuesday report, we present an alternative view of the LTCBTC pair.
The LTCBTC ratio is common and directly tradable on many platforms.
However, there is a big disadvantage when trading the LTCBTC pair: no clean risk/reward can be expressed a priori in USD.
A hedge ratio, which is a classic pair trading strategy, provides an alternative. To do this, we briefly need to demonstrate an assumed linear relationship between BTC and LTC.
Let us assume that the following relationship between BTC and LTC applies:
BTC_Price(t) = 250*LTC_Price(t)+ ε (I)
If we now rearrange this equation, we get:
ε = BTC_Price(t)-250*LTC_Price(t) (II)
The variable ε represents the residual value versus our model.
Let us assume that the BTC price is BTC_price(t) = USD 50,000, and the LTC price is LTC_price(t) = USD 180. If we put these values into equation (II), we get:
ε =50,000-250*180 = USD 5,000
Consequently, at these prices, we obtain a residual value of USD 5,000 versus our model. More intuitively, the LTC is undervalued compared to our assumed model. When setting up a trade, a risk/reward can now be expressed in USD. The following trade could now be set up:
Trade Assumption: Our model from equation (I) is true. Consequently, the prices of BTC and LTC should move so that ε = 0.
Target Profit: USD 50,000
Max Loss: USD 25,000
In order to achieve this target profit, 2,500 LTC would have to be bought and 10 BTC would have to be sold. The take profit would be at ε = USD 0, and the stop loss would be at ε = USD 7,500.
At this point, please forgive me for omitting all statistical basics and formalities. If you are looking for more information on pairs trading, I can recommend reading the book Algorithmic Trading by Ernest P. Chan. It offers is a good and digestible introduction to this topic.
Now, let us get to the actual analysis.
The chart below shows the linear relationship between BTC and LTC introduced above (1*BTC-250*LTC), which represents the current residual value ε. If we now place a Bollinger band over this residual value, we get an oversold-undersold tendency between BTC and LTC. If the residual value is above the Bollinger band, then the BTC is oversold against 250 LTC. If the residual value is below the lower band, the opposite applies.
As you can see on the daily chart, we are currently at the upper band at a level that we have not seen since February 11. In addition, we have the RSI on the residual currently showing a negative divergence (see black lines). Historically, the combination of overbought/oversold on the Bollinger bands and a negative divergence have led to good entries.
In my opinion, trades pro LTC are to be favoured over the current environment of bitcoin.Read more