Narrative Trading #2: Thesis & Invalidation

Probabilistic thinking that lays the foundation of setting your thesis

Welcome to my short series on how to trade narratives. This is my attempt at making a short series of articles on how to narrative trade. I hope it helps! The first article can be found below.

Narrative Trading #1: Introduction - How To Find Alpha & Research

A Primer On Probabilistic Thinking

Moving forward, I will assume you have read previous articles. So at this point, you have a certain project/token that you’re looking at, and you’re wondering - how do I evaluate this?

The answer lies in probabilistic thinking. Probabilistic thinking forms the cornerstone of all trading. It is an essential skill in the toolkit of any trader, for our work is one where we grapple with uncertainty on a day-to-day basis.

Probabilistic thinking is, simply put, the idea that we think of events in terms of probabilities. When we don’t know all the factors in an uncertain situation, we have to rely on what we already know, and by making certain assumptions, we can assign probabilities to certain outcomes and bet on the one with a higher probability.

For example, you have a jar with 99 black balls and 1 red ball. The chances of you pulling a black ball are 99%, and the red ball 1%. Now, you’re asked to pull out a ball and guess its colour. Applying probabilistic thinking would mean that you’d guess the black ball because it has a higher probability of happening.

The caveat here is that it’s not impossible to draw a red ball though. And that’s where Expected Value (EV) comes in. By calculating the expected value, you get, on average, the amount you’d tend to obtain. That’s the core fundamental principle of trading - by taking enough bets with a slight probabilistic edge in your favour (e.g 55%), over a large enough number of trades, you’ll tend upwards (with proper risk sizing, of course).

Anyways, you can read a more detailed breakdown by Farnam Street here.

Creating A Thesis

Now, as CryptoCred says in his videos - you take a trade because you have an idea of what a coin is going to do. That’s what a thesis is - you do your research, and you think that the coin will go up because of X reasons.

The makings of a thesis can vary depending on what kind of trader you are - if you’re a technical trader, you’d probably have specific sets of technicals that you look at to make you think that probabilistically, this trade would turn out in your favour rather than not (e.g Moving Average convergence / divergence).

Since this is a narrative trading guide though, I’ll be focusing on narrative trading theses. Now, in my opinion, there are a few different kinds of narrative trading theses:

1. The News Trade / The Catalyst Trade

2. The Correlation / Flavour Of The Month Trade

3. The “Venture” Trade

The News / Catalyst Trade

These are the same “type” but differ in their timeframes. The core idea is that there’s some piece of information out there that other people don’t know about, but you have a hunch / direct access to it. This is also known as information asymmetry. News trades would be like knowing that $AVAX decided to partner with Amazon / Shopify before it happened. These trades normally see a short-term pump that fades because the news doesn’t inherently change the asset, but it’s just bullish in the short term. Other examples are $LDO 2.0, $dYdX and the investor delays, etc.

The issue with news trades is that, unless you’re part of the team, it’s super hard to get access to this info early. That’s why people pay for services such as tier10k to get the news just 10 seconds beforehand.

Catalyst trades are in the same realm. There’s some piece of information, just that maybe this information is more detailed. For example, knowing that $BLUR is going to airdrop, you long $LOOKS because you know that $BLUR acts as a catalyst that will set off NFT coins. Or another example is the dYdX v4 chain launch.

The Correlation / Flavor Of The Month Trade

This one’s simple - in a bull market, there’s always a coin that just outperforms. The reason for the pump doesn’t matter - all that matters is that you recognise it. In this mini bull run, we have had $APTOS, $LDO & $OP do this.

And CT being CT hates longing things that have “already pumped” - hence the correlation trade. Assets that are “correlated” - e.g any LSD token, sees a pump just because LDO pumped.

The “Venture” Trade

These are my favourite sorts of trades. I like em because I feel like you have to do actual research - they’re similar to catalyst trades, but differ in the sense that the information isn’t as readily available - that way, there’s a greater informational asymmetry that is actually readily available if you bother to do the research. You bet on these because like venture firms, you believe that in the coming weeks / months people will start accumulating this because of the good “fundamentals”.

Good examples are longing $CANTO before anyone knew about it, or $MAGIC before anyone knew about it last cycle.

Putting It All Together

Now that I’ve briefly outlined the structure of a few different types of narrative trades, we move on to the next step. As I said, every trade is an idea, and but all ideas have a bit of uncertainty in them. That’s where probabilistic thinking comes in. So, you have an idea - but you also need to assign certain probabilities of certain events happening.

This is where the fun of trading happens. As you trade more, you become aware of the different events that will happen, and basically create your own proprietary system where you have your own set of factors that help you determine if a trade is good or not.

You think of all possible scenarios and second-order consequences and assign different probabilities. An example is:

1. Overarching macro structure - 50%

2. Token research (founder/narrative / etc.) - 50%

Obviously, this isn’t that detailed, but you get the point. Your system is key.

Knowing Your Invalidations

You’ve found a project you like, you’ve done your DD, and are now building your thesis. Your thesis goes something like “this coin is undervalued because of XYZ factors. I believe that it’ll see momentum because of ABC pumpanomics.”

Now you have to form your invalidation - i.e the key area in which your idea is deemed wrong. Invalidations are heavily intertwined with the thesis itself, and have to be of the same “type”. After all, you can’t say that “Oh, I’m long $MATIC because they’re launching a zk-EVM soon” and then you say “I cut $MATIC because I saw a black cat and that’s bad luck.” The reasons for cancelling the trade have to be in line with why you took it in the first place.

To be frank, I’m still working on creating good invalidations. The problem with narrative trading is that a lot of it is based on momentum, which is an extremely hard indicator to gauge.

I myself also favour the more behavioural side of trading, so I tend to look at sentiment. But sentiment is an emotion that is hardly calculatable in the realm of finance, and I suffer a lot when I have to explain to people “just sell, people are euphoric”. They normally ask for data in which I’m unable to produce, so I’m still actively working on that front to find a suitable momentum indicator.

But I digress. A good invalidation is key to knowing when to pull your trades, and is extremely important in cryptocurrency where prices can swing wildly.

It has to be in line with your trade idea, and you have to think - at what point will my thesis be invalidated? When the team changes? When the catalyst gets delayed?

These answers form your invalidation.

Concluding Thoughts

I hope you have been enjoying this series so far! Let me know if you have any questions in the substack chat~

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