The cryptocurrency market is one of the most volatile and unpredictable markets, thereby fertile ground for traders and researchers trying to decode its appealing price dynamics. Among the many under active exploration, one phenomenon stands out as quite interesting, the momentum effect which follows one day abnormal returns. These volatile and asymmetric price fluctuations in electronic currency markets—surges in Bitcoin, Ethereum, or Litecoin prices often lead to a phenomenon called overreaction whereby the prevailing trend in prices will either be reinforced or reversed.
Overreactions can be tricky because they hide the patterns that inform profitable trading systems. Its understanding and exploitation are critical to developing efficient short-term trading strategies.
Because they are decentralized and innovative, cryptocurrency markets are inherently volatile. Prices respond to a whole range of causes, from changes in the underlying technology to regulatory adjustments, macroeconomic events, and even investor sentiment. Indeed, irregularities such as momentum effects are very hard to detect, but they represent some of the most promising lines of attack to take advantage of short-term price trends.
The complexity of this issue made researchers Googly Elmo, Maria Karali, and Alex Platon present a deep analysis of the momentum effects that come after one-day abnormal returns. These developments are based on multi-year data analyzing the patterns of over-reactions and what happens afterward. This is helpful information for traders and investors in these uncertain cryptocurrency markets.
Momentum Effect in Cryptocurrency Market
Momentum effects are the continuation of asset prices in one direction or the other after experiencing a large abnormal return over one trading day. For cryptocurrencies, which have very extreme price volatility, the markets become even more sensitive to short-term trends and can thus be leveraged by traders to generate short-term returns.
Under such circumstances, momentum effects may be a significant guide in indicating future price action. The said effects are highly exploited by the traders as they seek to sustain the momentum in the expected trend. However, this uncertainty makes it less reliable compared to equity markets in the currency market- cryptocurrency-.
One of the main drawbacks of momentum effects in cryptocurrency markets is that they are very short-lived, especially right after a one-day abnormal return. However, the study by Elmo, Karali, and Platon helps to reveal the extent of momentum effects and their real-life applications to guide traders on how to handle this volatile market.
Research Focus and Methodology
The research by Elmo, Karali, and Platon used intraday price behavior of three of the largest market cryptocurrencies relative to the US Dollar, namely Bitcoin (BTC), Ethereum (ETH), and Litecoin (LTC). The period of observation was from 1 January 2017 to 1 September 2019.
They applied statistical analysis along with simulations of trading activity to test the hypothesis that one-day abnormal returns are what set off momentum effects. Specifically, they tried to answer the following questions:
The study answers these questions and thereby reveals more insight into mechanisms that drive price movements in cryptocurrencies and whether momentum effects can form the basis for effective trading strategies.
Hourly Returns on Overreaction Days
The study indicates that overreactions set an environment for extraordinary price movement with either positive or negative hourly returns compared to regular days. In conclusion, the setting of such an environment might support the existing trend. For instance, findings reveal that traders may be more prepared for overreactions by being able to foresee increased volatility and exploit the momentum amplification that will occur on those days.
Identification of Overreactions Beforehand
This makes a very interesting observation: it indicates, based on one of its conditions, that there are significant possibilities when overreactions occur; therefore, the former can often be identified even when there is an hour left over before the day ends. Researchers set certain conditions specific to time under which such phenomena could be isolated early in trading days. Identification of an overreaction at some point during trading days leaves those traders ample momentum effects prior to the closure of trading sessions.
Day-of-Overreaction Momentum Effects
The authors found that on overreaction days, prices continue to move in the direction of the initial overreaction until the close of the market. This result highlights the influence of momentum in short-term price movements and supports the idea that traders can exploit the trend by aligning their strategies with it.
Momentum Effects Persist into the Next Day
The authors were also surprised to find that the spillovers of momentum into abnormal returns frequently spread to more than one trading session. Such a spillover could, again, afford a short-term trader one more chance at capturing momentum.
If momentum indeed spills over into the following trading sessions, strategies may then be formulated based on a maximum profit opportunity for the traders.
Contrarian Effects in Specific Events
Probably one of the most significant discoveries that can be gleaned from this research is evidence about contrarian effects in some conditions. In some instances, researchers have identified instances in which price movements for Bitcoin-USD and Ethereum-USD pairs reversed against expected momentum at times. Contrarian effects, therefore, become manifestations of the unpredictable nature of cryptocurrency markets that call for very serious analysis and risk management.
Inferences to Traders and Investors
The findings in this paper have a number of practical implications for cryptocurrency traders and investors: profitable trading strategies.
A foundation from which profitable trading strategies may be developed, momentum effects may also allow a trader to gain entry to positions that continue to benefit from price movements by detecting overreactions early in the trading day. Further opportunities to exploit short-term trends may be provided through the persistence of momentum effects into the following day.
Risk Management
Contrarian effects indicate that the demand for appropriate risk management techniques is humongous. For example, even the momentum strategy appears to work most of the time; however, there can be some unforeseen reversals that are brutal. The stop-loss orders can help reduce or eliminate the risks and protect the investment made by the traders.
Market Anomalies and Arbitrage Opportunities
The study identifies inherent anomalies in the cryptocurrency market that can be exploited through arbitrage strategies. Such anomalies include price discrepancies across exchanges or deviations between expected and realized market movements. The identification and leveraging of such opportunities enhance the profitability of traders.
Conclusion
Research by Googly Elmo, Maria Karali, and Alex Platon really does give great insight into the momentum effects witnessed in cryptocurrency markets following one-day abnormal returns. It has thus helped shed light upon the short-term dynamics of price movements, and this insight might be a real help for the traders navigating such a volatile market.
This opens avenues for effective trading strategies by momentum, overreactions, and contrarian behaviors. Although these insights add more depth in understanding the behavior of the market in cryptocurrency markets, they open avenues for further research into the anomalies and patterns of pricing of the markets.
It thus provides the traders and investors an opportunity at winning besides managing risk. The momentum effects applied to those lines have subtleties that will create the possibility of earning maximum returns by market participants as well as negotiating challenges occasioned by volatility and unpredictability in the cryptocurrency market.