Crypto momentum trading is a practical strategy to generate returns in a volatile market by leveraging technical indicators and market trends. We’ve created a comprehensive and in-depth guide to a proven strategy honed over the past five years.
The essence of momentum trading is in the investor’s capability to recognize trends and swiftly make a decision. By the end of this guide, you should be able to understand the underpinnings that drive momentum trading, build your own approach, and explore automated options.
Introduction to Momentum Trading
Momentum refers to the speed at which an asset’s price changes. Momentum trading is a strategy that seeks to capitalize on the inertia of a price trend—whether a specific price will continue to rise or fall over time.
Think of market movement and momentum as a car. When a car starts to accelerate, it first moves very slowly. Once you’ve reached the highway, the car stops accelerating but remains traveling at a high velocity. As it arrives to its destination, it decelerates and slows down.
For the momentum investor, the best time to invest is in the middle, when the car is moving its fastest. The best time to get out is at the exit, once it shows signs of slowing down.
What is Momentum Trading?
Momentum trading involves buying assets based on prevailing trends, aiming to capitalize on price volatility. For instance, traders might purchase an asset during an uptrend and sell it when signals suggest a reversal.
Why does Momentum Trading exist?
In a rational market, experts would struggle to explain the phenomenon of market momentum. The difficulty is that increased asset prices should not warrant further increases. Yet, historical evidence has proved momentum as a real phenomenon. The explanation for this event can then only be irrational.
Momentum trading is rooted in behavioral economic principles, particularly herd instinct and regret aversion.
Herd instinct leads people to follow the majority, while regret aversion makes them avoid decisions they might later regret. For instance, as one group starts buying Bitcoin, others may join to avoid missing out.
As one group starts buying a particular asset, others follow suit.
As a concept, herding isn’t necessarily “wrong”. It can be beneficial if the investors you’ve followed are well-informed individuals who’ve done their research with sound fundamental analysis. To conform is a natural human instinct that is difficult to fend off, making momentum trading a viable strategy for every investor.
Core Principles of Momentum Trading
Momentum trading operates on the core belief that “the trend is your friend.”.
A price trend occurs when an asset’s value consistently moves in one direction. Whether the price moves upward or downward, momentum traders focus on recognizing and acting on these trends before they reverse.
Market signals play a vital role for all traders. Key concepts include:
- Higher Highs and Higher Lows: indicative of a bullish trend.
- Lower Highs and Lower Lows: indicative of a bearish trend.
- Trend Strength: measured through the Relative Strength Index and Moving Average Convergence Divergence (MACD).
- Market Volume: trading volume can indicate an impending reversal.
Market signals like these help investors identify potential entry or exit opportunities.
For example, the Relative Strength Index (RSI) is an indicator for price trends. It is calculated by dividing the average gain by the average loss of an asset over a specific period.
Based on the quotient, the asset can be categorized as overbought or oversold – with the thresholds at 70 or 30, respectively.
For example, if Ethereum’s RSI dips to 25 (below the oversold threshold of 30), then this could indicate a potential buying opportunity once momentum reverses.
Spot vs Derivatives Momentum Trading
Momentum trading in cryptocurrencies can be executed in either the spot or derivatives market.
The primary difference between spot and derivatives trading is that spot trading involves buying and selling the underlying asset. In derivatives trading, you deal with contracts tied to an asset’s value, allowing for strategies like short-selling. For example, a trader can profit from Ethereum’s price drop by opening a short position in derivatives i.e. short-selling.
Derivatives trading pairs well with momentum trading. Where spot trading only allows users to profit during uptrends, shorting allows derivative traders to profit from up and downtrends.
Step-By-Step Guide To Setting Up Momentum Trades
Because the cryptocurrency market is notoriously volatile, seemingly strong trends can quickly collapse within hours. Momentum trading in cryptocurrencies requires precise identification of trends. Here’s a streamlined process to identify movements and strategically enter trades.
Using technical charts and analytics tools
Technical analysis is a method of evaluating statistical trends in trading activity. It focuses on price and volume to draw conclusions about future price movements.
A core limitation of technical analysis is that while quantitative analytics can be applied to any security with historical trading data, history never repeats itself exactly as the overall economy and the industry conditions randomize results.
That said, there is still value in understanding trends through data-driven mechanics. Here are the 4 most common indicators used in trend trading:
- Moving Averages: Moving averages create a single flat line on a price chart indicating the average price over a period.
- Relative Strength Index: The Relative Strength Index tells us whether an asset is overbought or oversold.
- Moving Average Convergence Divergence: MACD is an oscillating indicator calculated by subtracting the long-term EMA from the short-term EMA. Combined with the RSI, MACD measures the potential of a trade reversal.
- On-Balance Volume: On-balance volume compiles the cumulative buying and selling pressure by adding the volume on up days and subtracting it on down days.
Monitoring market sentiment through news, social media, and crypto adoption trends can indicate trend reversals.
Identifying trends in the crypto market
There are two types of market trends: long-term and short-term.
Long-term crypto trends are primarily influenced by fundamental factors such as tech innovations, macroeconomic events, and adoption rates. Long-term trends also tend to impact all virtual currencies’ price trajectories.
In contrast, short-term crypto trends take place over days or weeks as influenced by news events, market sentiment, and trading activity.
Both types of trends can be cross-validated with one another to paint a clear picture of where we are in the overall market cycle. Understanding on which timeline you’re investing or trading also helps you plan your entry and exit points better.
Entry and exit points: How to decide when to buy and sell
Entry opportunities often arise during breakouts, when prices exceed key resistance or support levels with strong volumes. Analytics tools become key players in confirming the trend; MA crossovers and volume surges reinforce existing notions.
Here’s a three-step process for setting up trading entries:
- Enter during breakouts with volume.
- Use confirmation indicators to verify surges.
- Avoid chasing the trade: many beginner traders struggle to take profit at their targeted range for fear of losing out on more gains. There are plenty of opportunities in the market.
For exits, remember to use stop-loss orders and set take-profit levels. These ranges limit potential losses and secure profits before market downturns.
Consider key resistance and support levels by learning to study candlestick charts. These are often reliable metrics for entry or exit points as they also create trendlines that show if an asset’s price is moving higher or lower long-term.
Backtesting strategies with historical data.
Finally, backtesting strategies against historical data can be used to evaluate reliability and refine approaches. Traders often collect historical price data and then simulate trades based on their entry and exit points.
From here, the simulated trades are tracked with their performance metrics measured. As you simulate trades, make sure to take note of the win rate, average profit/loss per trade, and maximum drawdowns of your strategy.
These help identify strengths and weaknesses that improve your strategy.
By following this systematic approach, you can set up momentum trades with greater confidence and a higher probability of success. We’ll discuss specific case studies of backtesting strategies in the following sections.
How Peccala’s Trading Engine Works
Peccala’s Trading Engine uses algorithms that analyze various market metrics and every available crypto asset once per hour. While the specific features and classifiers are kept private, we are happy to provide an overview of how our trading engine works.
Peccala’s Trading Engine uses a two-layer approach: the forecasting layer and the trading floor.
- Forecasting layer takes raw public data and enters it into a custom feature engineering pipeline that calculates the probability of the market going up or down.
- Trading floor refers to the second layer of our engine, that deploys multiple trading bots, each with unique strategies (or trading “personalities”). Each bot is assigned different parameters that determine how it assesses assets. Frequency of trading, period, and trading volume are examples of parameters we will alter.
Each bot is assigned an equal share of the funds in the trading wallet. When two or more bots agree to a decision, their share is pooled into a position. When two bots choose to invest in different directions, their shares cancel each other out.
This way, our trading is robust and diverse, covering a wide range of market conditions and investors.
Case Study: Momentum Trades in Action
Peccala has two trading strategies: the High-Risk Token(PECH) and Medium Risk Token(PECM). The main difference is that the PECH strategy trades crypto perpetual futures using 2x leverage.
Because our trading strategy uses derivatives, PECH trades can go long (speculating that the coin's future price will be higher than today) or short (speculating that the future price will be lower than today). Regardless of the trend’s direction, Peccala continues to make money.
This is Peccala’s returns for our High-Risk Strategy over the past 4 years, presented on a logarithmic scale.
Over the last 4 years, PECH would grow 77x, beating BTC and ETH which would grow 2.65x and 2.63x in price, respectively.
Concluding Thoughts
Momentum trading in crypto is complex and risky due to market volatility. Peccala simplifies this process by automating proven strategies, enabling investors to capitalize on opportunities without constant monitoring.
With Peccala, customers are able to employ a proven momentum trading strategy and actively invest in crypto assets through a single Token.
Explore how Peccala’s algorithmic technology can enhance your trading experience through our litepaper.
