What to do in case of a market crash? Learning these operations can help you avoid being trapped

This article was published on Chain Finance.

When pressure arises in the traditional world, there are many safeguards to ensure market orderliness. After learning painful lessons about the snowball effects that volatile markets can produce, these tracks have been put in place. Mechanisms like circuit breakers and central bank interventions (which are less common) occur during periods of excessive volatility in traditional markets, as they allow market participants to pause, breathe, assess, and take action rather than being forced to make real-time decisions and add margin. Through firsthand experience of market events, many participants have come to an agreement on these rules to avoid pain.

In the crypto market, this is a completely foreign concept. Participants in the cryptocurrency market tout the true essence of freedom as a selling point, a beacon of a new era, a wild natural experiment that everyone can experience. Of course, this lack of safeguards leads crypto investors to experience spectacular bursts and crashes approximately every six months, often watched with fear by outsiders.

As an active trader, you enjoy these moments. For savvy market participants, overly volatile and fearful markets are often the best for trading, as they can identify and exploit structural breakouts that frequently occur during these contractions. Exchange drops, forced liquidations create high EV buying opportunities, futures products deviate from their indices, options can reach extremely high IV, and on-chain liquidations can drive arbitrage opportunities. For market participants with cash deployed, this is a verifiable feast.

As a relevant example, on Deribit, you often see IV skyrocketing due to market makers widening the market or accounts becoming forced option buyers through liquidation. Typically, you cannot sell large volumes at extreme IV levels, but usually, small investors can take advantage of these bursts to sell options at extremely high levels, with relative confidence that once market volatility subsides (usually occurring within 12 to 48 hours after the initial burst).

Back to 1987

On October 19, 1987, due to massive panic and margin calls, the Dow Jones Industrial Average fell 22.6% in a single trading day, marking the largest single-day drop ever. This was the first psychological collapse experienced by traditional markets in the era of automated trading, exacerbated by the preset nature of many trading decisions (such as the widespread use of stop-loss orders).

At that time, a drop of over 20% in a single trading day was unfathomable for most market participants, and the market's reaction to the decline was swift and severe. Regulators acted immediately to ensure safeguards to prevent a chain reaction of panic and forced liquidations, which they believed could be avoided.

The main rule established was the concept of trading halts. This "pause" method was actually tested in real-time during the 1987 crash, as Nasdaq experienced an exchange failure where stocks only fell 11%, about half the drop of the S&P 500. Thus, regulators could point to a natural experiment, and by January 1988, the SEC was drafting relevant regulations (now known as Rule 80B) requiring exchanges to halt trading on securities that reached specific volatility thresholds.

The situation most similar to the funding contractions that have always existed in cryptocurrency is that we experience multiple events similar to 1987 each year, where high leverage, inefficient collateral, and a panic mentality lead to significant sell-offs. Unlike the traditional world, the crypto world has almost no measures to prevent it from happening again. Some exchanges like Deribit are quite aggressive and have introduced sub-second halting mechanisms (triggering a stop-loss if prices fluctuate more than 2.5% within a second), but the vast majority of exchanges lack such protections, ensuring that the crypto space can maintain a leading position during these contractions for some time.

May Crash

On May 19, 2021, Bitcoin plummeted about 20% in 45 minutes, and in the following 2 hours, Bitcoin retraced the entire drop. This move was the result of evaporating spot buying, excessive exposure to high beta assets, and a general market weakness due to a lack of off-exchange capital.

On that day alone, Bitcoin futures products saw over $3 billion in liquidations, not including the liquidations of altcoin futures. The speed of liquidations and the crash that day sent the market into a frenzy, resulting in various chaos. The mechanisms of the sell-off have been widely discussed, so most discussions will focus on the areas where the market became dislocated due to extreme and rapid fluctuations.

Futures + Spot

One of the most common events in high-pressure markets is the liquidation of futures positions, which often pushes futures prices to extremes.

Due to high demand for leverage, futures products typically trade at a futures premium (meaning their trading price is above the spot market's settlement price). This makes buying futures in a spot premium (where the trading price is below the spot market's settlement price) an enticing opportunity. In the recent crash, the annualized rates for Bitcoin quarterly futures fell to a low of -13%, while ETH quarterly futures rates dropped to a low of -23%.

Data: Skew.com

Both futures products quickly recovered from the spot premium state back to the futures premium state, and those who managed to fill these futures due to forced selling ended up very pleased. This is a simple example of market inefficiency that savvy traders can exploit if they pay close attention. For those looking to build long positions during the next "surrender," it may be wise to look for futures as an alternative to buying spot during declines.

Forced Buying

When the spot market experiences massive fluctuations, market makers often widen their markets on the options book, and in some cases, due to the uncertainty of market conditions, you find extremely low liquidity. To clear short option accounts, Deribit sometimes uses futures to hedge option exposure but also attempts to offload option positions—creating (often) forced purchases of certain strike prices and instruments.

Due to liquidations and unstable liquidity, you often see extremely high implied volatility, and once the market cools down, you should be able to sell it as a relatively high expected value. Note that in the recent market structure, DVOL actually spiked twice, once during the initial crash and then again during the subsequent pullback (even more forcefully). In the following 24 hours, both instances of significant volatility encountered pullbacks.

Data: Deribit.com

Forced Selling

A more subtle version of market dislocation is the concept of "forced selling," which is a positive place for deploying new capital, betting on the notion that once the requirements for liquidation and margin calls are fully passed, there will be a lack of natural selling at price levels, allowing assets to rebound significantly.

For example, Bitcoin rebounded about 20% from its low in one hour on May 19, Ethereum rebounded about 35%, and Uni rebounded about 50%. These significant increases were possible because a large portion of the sales were forced liquidations. Forced selling typically occurs at the most inopportune prices, as batch liquidations happen during peaks of market pressure.

If given the opportunity, most forced sellers would not be inclined to sell at the prices they exit at. This is why a system that only sells part of your position during incremental liquidations (like the one Deribit has) is often superior (from the client's perspective) to a complete liquidation system, which sells your entire position upon reaching maintenance margin.

Cascading liquidations often present some of the best buying opportunities. Once liquidations are complete, the market typically rebounds higher, as the primary sources of selling in the market have now diminished. To take advantage of this inefficiency requires a bit more expertise than simply buying discounted futures or selling high IV, but opportunities still exist.

DeFi

In the recent sell-off, DeFi actually performed better than expected, with key systems not experiencing major failures—but that doesn’t mean there weren’t opportunities to exploit. First, when the market rapidly reverses, you often find a large number of liquidations from lending platforms like Compound and Aave, where complex liquidation bots can take advantage of these platforms.

Secondly, since AMMs rely on arbitrage to maintain pricing consistency, rapidly changing markets on centralized exchanges often introduce significant price discrepancies. Typically, the price differences between centralized exchanges and AMMs like Uniswap and Sushiswap are too small for non-complex bots to exploit, but when the market changes rapidly like on May 19, you find that the price discrepancies are sufficient even for ordinary bots.

Conclusion

In the chaotic golden age, traders are fortunate to seize such opportunities. These situations may persist until enough idle capital enters the crypto ecosystem to clearly smooth market operations. Other exchanges beyond Deribit may struggle to introduce more market safeguards—which would benefit market stability but be detrimental to active traders.

Future regulations may also target these issues to ensure the market operates more orderly, especially as more investment firms focus on potential ETFs.