In 2017 Crypto Markets Continue to Trend Higher with Momentum
It is evident that cryptocurrencies have been in a trending market for the past two years, or some would argue, since their inception. Every $1000 invested into a basket of Bitcoin, Ethereum, and Litecoin at the beginning of January 2017 would nicely turn into $18,000 in just 11 months; completely unheard of when compared to returns posted by more traditional assets, such as stocks, bonds, or commodities.
Crypto returns outperform equities
Fortunately for newcomers to the space and institutional players, the large upside in cryptocurrencies might actually be sustainable for another two or three years as blockchain technologies start disrupting business models for an entire range of industries; from banking to supply chain, healthcare, legal, government and marketing, among countless others that aren’t even considered as of this writing.
Many renowned investors have already claimed that the crypto space is in a bubble, implying potential downsides are imminent. However, for every drop that has occurred, the crypto-economy has held to its long-term trend, and the downside has recovered. The chart below shows with ease that crypto markets must appreciate another 20 times to reach the magnitude of the dotcom bubble from 2000.
Crypto market versus the Dotcom bubble
Contingent crypto markets keep appreciating at an above-average rate; this suggests we should apply growth trading strategies which seek gains by capitalizing on absorbing abnormal returns. These types of strategies which focus on using Momentum and Relative Strength Index (RSI) could easily benefit investors seeking to beat the market on both absolute and risk-adjusted basis. Let’s take a closer look at what these strategies can offer investors.
What is Momentum Investing?
Momentum investing has been a fairly novel concept that has evolved out of cyclical and structural patterns in global economy in a number of traditional security markets including equities, commodities, and FX. Scholars have been studying and writing on momentum strategies since the early 90’s.
If we are to draw the parallel with, say, horse racing, momentum investing says that you should bet on the horse that came first in the previous race. Momentum investing can be summarized in the two following principles:
- Purchasing top performing assets from the previous 3, 6, 9, or 12 months can result in abnormal profits after holding each portfolio for 3, 6, 9, or 12 months.
- Shorting worst performing assets from the previous 3, 6, 9, or 12 months can result in abnormal returns after holding each portfolio for 3, 6, 9, or 12 months.
The whitepaper composed by AxionV team found the validity of momentum investing when it comes down to the crypto markets as well. As found by the whitepaper’s analysis, momentum investing strategies outperform the general crypto market benchmark on the basis of both absolute and risk-adjusted return.
Application of Momentum
What’s the best way to identify the best performing token in the previous period, say in the previous month?
Investing.com has historical daily prices for some of the top cryptocurrencies, such as Bitcoin (BTC), Ether (ETH), and Litecoin (LTC). Examining price behavior of BTC-USD, ETH-USD, and LTC-USD pairs in the last month would give you a monthly return for these three cryptocurrencies.
After figuring out the monthly performance of BTC, ETH, and LTC, it is time to decide on allocation weight. It is an art, not a science, to decide on which allocation works best. If you try the weight allocation suggested in the table below with the monthly rebalancing, momentum strategy would bring the following results since September 2015.
What is the RSI and How can it further Optimize Returns?
As shown previously, momentum investing alone has evidence to improve capital gains substantially. However, gains could be optimized even further by adding another interesting momentum oscillator.
The Relative Strength Index (RSI) is a technical indicator used in the analysis of financial markets. It is intended to chart the current and historical strength or weakness of an asset or market based on the closing prices of a recent trading period. The RSI oscillates between 0 and 100. Traditionally the RSI is considered overbought when above 70 and oversold when below 30. Thus, in mean-reverting markets, the asset should be sold when the RSI level is above 70, and the asset should be purchased when the RSI level is below 30.
When it comes down to trending markets, overbought assets tend to keep rallying, and oversold assets tend to keep falling off the cliff. Thus, the RSI oscillator can help indicate moments of additional interest from investors and capitalize on shorter-term market excitement.
The fastest way to learn how to compute the RSI index is by following one of the online tutorials, such as the one located on the following link; here’s how to compute RSI with a 14-day rolling period. Let’s add one more feature to the analysis of the RSI index.
Crypto markets are trending at a pretty steep slope, making it hard to distinguish shorter-term upswings and downswings of individual cryptocurrencies. It is a good idea to construct the RSI of market-adjusted returns for every token in our analysis to get a more accurate view of temporarily overbought and oversold assets with the RSI indicator. If we subtract average market return, which could be computed by calculating returns of a crypto basket with, say, 80 percent allocated into BTC, 16 percent into ETH, and four percent into LTC (according to rough market cap comparison of these three tokens), and then compute the RSI oscillator, the success rate would be a little bit more predictable.
COMBINING MOMENTUM AND RSI
Now, as we have two indicators, momentum and RSI, we could use the following table to assign weights to cryptocurrencies in a portfolio.
The results of absolute return versus risk-adjusted return can be found in a graph below. What’s interesting is that trading strategy of Momentum & RSI showed not only the highest absolute return but also the highest Sharpe ratio (or risk-adjusted return). All it required was a monthly rebalancing of the basket based on Momentum investing strategy and subsequent shorter-term trades signaled by the RSI oscillator.
Suggested weights provided in this guide are not brick and mortar. In your back-testing, please experiment with the allocation proportions and see which ones result in higher risk-adjusted return. The absolute return should be secondary since successful traders and investors are the ones who have their risk management in place.
Based on using both RSI and Momentum strategies combined in a market like cryptocurrency, we can anticipate a larger gain of up to nearly two times (1.93 times exactly) the gains over a two year period than just investing and holding in a crypto basket. Note, this implies monthly rebalancing, not day trading or positional trading. Our Sharpe ratio minimizes the downside risk for higher momentum volatility and actually beats the other. While the fact the market has seen gains, our Sharpe ratio still outperforms a momentum only or “buy and hold” basket with an increase of 3.6 percent for the Sharpe Ratio.
For investors wanting exposure to this space with adjusted gains and limited downside, it’s imperative that advanced strategies, and even old-school technical analysis are used. Nothing beats solid diversification and risk management to achieve long-term growth, no matter how volatile a market gets.
Co-authored by Morgan Hill