FROM THE VAULT: The Momentum Effect in Crypto

In this article, we will delve into the phenomenon known as the momentum effect, explore its unique implications in the cryptocurrency markets, and provide actionable strategies for capitalizing on this common inefficiency. Whether you're a seasoned trader or a curious newcomer, understanding the momentum effect can give you a significant edge in the dynamic world of digital assets.

Momentum is the longest-standing, best-studied inefficiency in the financial markets—one that offers a potential of unparalleled returns. Unlike traditional assets, where gains are often tethered to fundamental constraints, the momentum effect in the digital assets space presents a unique opportunity, providing a higher total return potential.

The Momentum Effect Explained

Definition:

The momentum effect refers to the tendency of an asset's price to continue moving in the same direction for a period of time. In essence, assets that have performed well in the past are likely to continue performing well in the near future, and vice versa for poorly performing assets.

Historical Context:

First observed in traditional financial markets, the momentum effect has been a well-documented phenomenon for decades. Academics and professional traders alike have studied how past performance may predict future price movements, leading to profitable trading strategies in stocks, commodities, and now, digital assets.

Momentum Effect in Crypto Markets

Unique Characteristics of Crypto:

Digital assets are known for their volatility, 24/7 trading, and fast cycles with many inefficiencies. These factors create an environment ripe for momentum trading. Rapid information dissemination through social media and forums can cause swift and significant price movements, which momentum traders seek to exploit. The lack of fundamental based evaluation methods makes the prices mainly driven by speculation and hype.

These hype cycles can be extreme in both directions. Fast rises in asset prices are often followed by sharp declines with most assets falling +90% and never recovering. These extremely volatile cycles make buy & hold of assets besides BTC and ETH very suboptimal. You need a way to participate in the upside but limit your downside.

Case Studies:

Take, for example, the dramatic rise and fall and rise of Solana from 2021 to today, where prices surged from $39 to nearly $250 on Coinbase within a few months. Followed by a dramatic 94% decline to $9. In the rally starting in 2023, it then manages to rise again to $200 (see grey line below).

These boom and bust cycles are very common in the digital asset space. However, 90% of assets only have one boom cycle and never recover after they decline +90%. Momentum strategies like the black line above can help you capture the upside while protecting you from the 90% drawdowns. If the asset never recovers, it does not matter as you are out of the market, if it does get another rally you can happily participate in the upside again.

Are you made for trading momentum?

Momentum strategies offer positive skew, which makes it extremely difficult to blow up as they cut losses quickly and add to winners. This results in an asymmetrical uncapped upside giving you the potential for these big lottery-type pay-outs, that people in crypto are looking for.

However, it is not all sun and rainbows. These properties come at a cost. The biggest cost is the low win rate. As with playing the lottery, most of the time you are just paying, which means you have lots of losing trades. Then occasionally you get your big payout - luckily with a well-structured momentum strategy, this happens more frequently than winning the lottery. In trading, people want to be right about their trades more than they want to make money. The many losing trades mean you are wrong most of the time. Coupled with the long periods of just losing, most people quit right before the big payouts.

There is no free lunch. Momentum strategies are able to provide the highest payouts because of the high potential upside at the cost of being in a drawdown most of the time. You have to pay in some way to get the rewards. Because most other people are not able to endure the pain you get paid for taking the risk. As with most things in life consistency and investing over a long time horizon is needed to reap the rewards.

Strategies for Capitalizing on the Momentum Effect

Identifying Momentum:

To identify momentum, traders can use many techniques from the well-known Relative Strength Index (RSI) to simple moving averages. The chosen measurement does not matter much as all approaches are highly correlated. However, most measures still provide some form of diversification which is why it is of uttermost importance to combine many different measures.

We use 30+ different momentum models to ensure robust results. Below you can see how the models perform on ETH. There is a wide spread of results. We never know which approach will work the best in the future which is why we need to combine multiple models.

The thick black line is the combination of the different momentum models. You can see how the ensembling method is superior to choosing any single momentum model. Every asset will have different models that work best for them. Therefore, it is very risky to only decide on a few models what if it turns out the model you chose is the worst in the future? Combine the models to get the best results. Our library of models is constantly expanding to stay ahead.

Picking the Pond

The technique used to measure momentum does not matter as much as the asset you trade it on. Any momentum model will make money in a trending market. However, if you trade noisy/mean reverting markets any momentum model will lose money.

With digital assets, we are already in a market that is very well suited for momentum strategies. Now it all depends on your ability to scan the vast universe of digital assets for the best momentum opportunities. The most common way to go about this is to buy assets with strong recent performance and sell those with poor performance.

The Future of Momentum Trading in Crypto

Technological Advances:

The rise of AI and machine learning has revolutionized momentum trading. Advanced algorithms can now analyze vast amounts of data in real time, identifying momentum patterns and executing trades with precision and speed that were previously unimaginable. This technological edge is becoming increasingly essential for staying competitive in the fast-paced crypto market. Our Regime Aware Asset Allocation Model for example takes our 30+ momentum models to categorize the market into different market regimes.

Market Predictions:

As more institutional investors enter the digital asset space, the momentum effect will become even more pronounced. With larger trading volumes and more sophisticated trading tools, the dynamics of momentum trading will evolve, presenting new opportunities and challenges for traders.

Conclusion

The momentum effect offers a powerful strategy for navigating the volatile world of digital assets. By understanding its principles, recognizing the unique characteristics of the crypto market, and employing effective trading strategies, investors can leverage momentum to achieve significant gains.