Following predictions as optimistic as the $100,000 forecast based on the stock-to-flow model, investors may foresee another period of high price speculation, opening the door for a wider set of investment strategies.
Since the start of the year, Bitcoin price has been as high as $9,200 – a 2-month high – while going as low as $6,900 on Jan. 3. Bitcoin’s volatility is one of the most frequently discussed issues that arise when investors evaluate Bitcoin as an asset class. However, its volatile behavior is what provides an opportunity for investors to take advantage of the price movements and make a profit.
On the other side, if investors end up experiencing a bearish scenario like the majority of 2018 and a portion of 2019, bolder strategies based on wide price movements may serve as a good alternative for market makers.
Cryptocurrency market weekly overview.
Strategies based on large price movements have been exploited for decades in traditional markets, especially in stocks. One of those strategies is momentum investing. An investor evaluates the daily returns for a sample of stocks and identifies which one was the biggest loser and winner in the price for that day.
In traditional markets, it was found to be lucrative to buy the winner stock that day and hold it for a certain period (up to investor discretion) and sell (short) the loser stock. Usually, investors develop this strategy based on portfolios of best and worst-performing stocks instead of only choosing the best and worst performer from the chosen sample.
However, it’s not uncommon for the individual momentum strategy to also be applied among investors despite raising questions about investment diversification. Nevertheless, if diversification is found to be ineffective in the crypto space, as reported by Cointelegraph, an investor might expect better results from an individual momentum strategy instead of focusing on portfolios.
How does Momentum investing work in the crypto environment?
Firstly, we identify the top-20 cryptocurrencies in the market today and get the daily returns for each currency during 2019. Throughout a portion of last year, we have seen a bearish scenario in the market. However, Bitcoin picked up and ended the year with a cumulative return of 65%.
By analyzing this strategy for a period with such characteristics, we can present a bolder strategy for investors to take advantage of bigger swings in smaller currencies since the biggest coins showed modest gains.
Secondly, we identify which was the currency that had the highest (winners) and the lowest (losers) return from the top-20 currencies for each day in 2019.
After identifying the daily winners and losers, we assume that an investor buys its closing price that day and sells it the following day, also at the closing price. The closing price (latest data in the range at UTC time given by Coin360) is assumed for simplicity purposes as it is open for investors to decide the desired time to buy and sell during those days. Another variation of the strategy can consist of holding the coin for more than one day.
By employing this strategy every day in 2019, we find that an investor who buys the winners gets the best cumulative return of 140%. Whereas, an investor that buys the losers and sells them the following day retrieves a negative return for this period (-105%). In traditional markets, the strategy works in the same way with the investor buying the winners and sells the losers.
Such volatile behavior leads us to also look at a risk-adjusted performance measure since an investor must be compensated by the exposure to higher risk investment. When exploring this strategy – buying the winners – a Sharpe ratio (the measure of risk-adjusted return of a financial portfolio) of 1.11 is achieved, excluding transaction costs, which is an acceptable performance for the strategy.
As we would expect, lower market-capped coins appear more often as the best or worst performing currency in the market: Chainlink (LINK), Tezos (XTZ) and Cosmos (ATOM).
The same currencies appear in both scenarios much more often than with other currencies. As we would expect, the higher market capped coins appear less frequently as the highest/worst performers (e.g. BTC, ETH, LTC, XRP).
Key factors in a crypto momentum strategy
Looking forward, an investor delving into these types of strategies should be aware of certain factors. The first is that we looked at the top-20 currencies in the market today and examined their returns for the last year.
Hence, some of the coins analyzed may not have been in the top-20 during some periods of 2019 as some may have just been recently launched or their volatility dislodged them from the sample. At the same time, currencies with volatile price swings may be included in some periods, raising the risk of the strategy but also the possible gains.
Another factor is the liquidity risk of employing such a strategy. When a lower market-capped coin sees a significant gain in price, it may be harder to buy it during a 24-hour period as most holders might expect the coin to go even higher or set very high sell limits for new investors to take advantage of this opportunity.
Finally, a strategy that is based on daily trading will incur high transaction costs. In this example, we exclude these expenses from the cumulative returns and Sharpe ratio calculations, which will cause a decrease in performance after computing the impact of operational costs.