Chief Scientist, Managing Partner at Invector Labs. CTO at IntoTheBlock. Angel Investor, Writer, Boa
Trends play a strong influence in the behavior of crypto markets. How many times we’ve heard expressions such as “crypto is a followers market….” Or “there is a FOMO sentiment in Bitcoin….”. When comes to translate those sentiments into investment models there are two core strategies that apply: momentum and trend following. Unfortunately, the immaturity of the crypto markets causes many people to use the two terms interchangeably when they have different connotations from a quantitative investment standpoint. Today, I would like to explore the differences between momentum and trend following in the context of crypto assets.
Crypto is a new asset class that is trying to reimagine many of the establish concepts in capital markets. The methodologies and investment strategies that work well in the crypto space are still in nascent stages and, quite often, we are trying to figure out which methods from traditional markets could be adapted to this new asset class. Being a completely digital asset class, it is natural to think that quantitative strategies such as factor investing will dominate the crypto space in the long run. However, many of the factors that have a strong influence in capital markets are not even present in the crypto space and others need to be heavily adapted to the specifics of crypto markets. Momentum and trend following are two factors that are likely to be relevant in crypto assets when applied in the right context. Both factors can be associated with price rallies or downturns but, are they really the same thing?
The fact that momentum and trend following are often used interchangeably in the context of crypto-assets is not surprising. After all, both factors try to measure trends or tendencies in the market. We can also attribute part of the confusion to the fact that crypto is a very nascent asset class and the foundations for quant models in the space, both in talent and infrastructure, are still in its infancy. As a result, people often take some liberties when explaining concepts such as momentum and trend following related to cryptocurrencies.
There is a simple rule to determine the difference between momentum and time series in the context of crypto assets:
Let’s dig deeper into the previous statement. To determine is a given trading strategy is momentum-based or trend-following based, we can use three fundamental criteria’s that will help two differentiate the two factors:
1. Individual Assets vs. Derivatives
2. Cross Sectional vs. Time-Series
3. Loopback Period
The most obvious difference between momentum and trend following strategies in the context of crypto assets are the underlying asset used to formulate the strategies. Here is a simple rule to differentiate momentum vs. trend following:
Momentum is a style factor that is evaluated against individual assets such as Bitcoin. Trend following is a macro-style factor that evaluates a trend in the group of assets and is typically built using derivatives.
For instance, a momentum strategy can measure the increment in the number of investors realizing profits over time such as the one provided by IntoTheBlock’s In-Out Money Analysis.
Contrasting with the previous example, a trend following strategy will measure the trends in the CME Futures Price compared to the S&P 500 in order to go long in one and short the other. Given the nascent stage of derivatives in the crypto, it is obvious that trend following strategies are very close.
Another element that differentiates momentum and time series as investment factors is the type of trend they are capturing. Typically, momentum factors are constructed cross-sectionally, meaning an asset’s momentum is compared to the momentum of other assets. Trend Following, on the other hand, is constructed using time series momentum, which focuses purely on an asset’s own past returns.
For instance, consider the following scenario that evaluates the network growth momentum for both Bitcoin and Bitcoin Cash using IntoTheBlock’s network actionable signal.
A cross-sectional momentum-based strategy will sell BCH and buy Bitcoin considering that Bitcoin has perform a tiny bit better. However, a time-series trend following strategy will sell both positions considering that they have both underperform based on the target indicator.
The final major difference between the two factors concerns the lookback period used to determine the momentum of an asset. In equities, momentum based strategies tend to evaluate a criteria over a longer period of time such as 12 months while trend following strategies operate in shorter time frames. The same difference applies to crypto-asset although the time frames might be smaller for both types of strategies.
These are some of the key differences between momentum and trend following strategies when applied to crypto-assets. In the current state of the crypto market, momentum strategies are certainly more viable than trend following methods. However, that’s likely to change in the near futures as the crypto derivatives market continues evolving.