It is no secret that bitcoin often displays exaggerated price moves. For example, the leading cryptocurrency pumped over 16% on October 25 on the back of President Xi Jinping’s announcement that China will focus their attention on blockchain technology.

While no technical analysts would have seen this massive move coming, traders can take a reactive stance and profit from such movements.

How would you trade these wild fluctuations? A working paper by Brunel University’s Guglielmo Maria Caporale and Alex Plastun provides some answers.

Momentum Effects in the Cryptocurrency Market

The research paper examines whether momentum effect exists after an abnormal one-day return for bitcoin (BTC), ether (ETH), and litecoin (LTC). Momentum strategies are popular with traders where they buy higher and sell higher (or sell low and buy lower) to take advantage of trending markets.

Abnormal one-day returns are termed ‘overreaction days’ as market moves are amplified on good or bad news (or sentiment).

Extreme sentiment can contribute to exaggerated price moves.

The results show that we can detect an extraordinary day in the markets before the daily trading session ends and that prices tend to continue to move in the same direction for the rest of the day, giving rise to profit opportunities traders can exploit.

The following formula is used to define a positive overreaction day as:

Ri > Rn + (k𝛅)

While a negative overreaction day is defined as:

Ri < Rn + (k𝛅)

Where:

Ri is the return on a given day,

Rn is the average daily returns from the sample,

k is the number of standard deviations to identify an overreaction (where k=2 for bitcoin and k=1.5 for ether and litecoin), and

𝛅 is the standard deviation of daily returns for the sample period.

Using cumulative average returns, the study found that we can identify a daily trading session that is exceptional in terms of price action at certain times of the day.

The abnormal returns are calculated as the return in an hourly session minus the average return in an hourly trading session, which are then added up throughout the day to obtain the cumulative abnormal returns.

How to Spot an Overreaction Day

To spot an overreaction day, we should look at the cumulative abnormal returns on an hourly basis.

If cumulative abnormal returns are increasing until the end of the day, we have a positive overreaction day. If cumulative abnormal returns are decreasing until the end of the day, we have a negative overreaction day.

Through the analysis of cumulative average returns, the authors found that 16:00 has been an important time of day for BTC, as usually negative overreactions can be detected by then. Similarly, 18:00 is another important time for BTC, as positive overreactions can usually be detected.

Since both are detected before the end of the trading day, this gives rise to a strategy that can take advantage of momentum effects in BTC-USD in real-time. When it becomes clear that the current day is one of disproportionate price action (using cumulative abnormal returns), open a position in the same direction and close it at the end of the day.

A Trading Strategy for the Day After an Overreaction

The paper also looked at whether momentum effects were present in the day after an exaggerated price move.

One of the key results was that a contrarian effect was observed for positive overreaction days for bitcoin — where taking a short position is more likely to be profitable. The trading strategy in this case would be to enter a short position at the start of the day after a positive overreaction and close the position after 16:00.

However, there is evidence for a momentum effect when there is an exaggerated negative move in bitcoin, where prices continue to move in a downward direction even during the next day. The paper highlighted that the timings were to enter a short position on the start of the next day and close the position after 11:00.

The table below shows all strategies for BTC-USD, LTC-USD, and ETH-USD.

If momentum effects are not present, a contrarian trading strategy should be employed (i.e., at the beginning of the next day enter a position in the opposite direction of the overreaction). Contrarian effects were observed in just two cases (for BTC-USD after positive overreaction days and ETH-USD after negative overreaction days).

The table above shows that a contrarian effect is uncovered for ETH following negative overreaction days. The strategy in this case would be to enter a long position on the start of the day following a non-typical day and then close the position at the end of the day. However, momentum effects are present when ETH prices have risen disproportionately, suggesting that you should buy on the open of the next day’s trading session and close the position after 21:00.

The authors of the paper also tested these strategies with simulations, with profits per trade ranging between 1.13 percent and 8.75 percent. For all the trading strategies for BTC, the lowest trade success ratio was 54.3 percent.

Interestingly, the two most profitable strategies were: 1) buying LTC on a positive overreaction day once we observe rising cumulative abnormal returns and, 2) selling BTC on a negative overreaction day once we detect falling cumulative abnormal returns.

Going with the flow on the day of an unusual price move is a profitable strategy for bitcoin, litecoin, and ether.

Trading Positive Overreaction Days

Using the recent BTC pump on the news from China, we can examine how to use the trading strategies highlighted by the Brunel University research paper.

The announcement that China was making blockchain technology a priority came through the wires on October 26, with the hourly price action shown below.

Trading bitcoin on a positive overreaction day, timings are highlighted by the vertical blue lines

After 18:00, we would have detected that there was a positive overreaction in bitcoin by looking at the cumulative abnormal returns, which would have been rising over the course of the day (or even just by the sheer bullishness of the price action that day).

The first strategy would be to enter a position in the direction of the trend and exit on the daily close. As shown above, you would have entered a long position on the open of the candle at $8,515.50 at 18:00 and closed the trade at 00:00 on October 26 at $9,214.50 (giving a profit of roughly $700 per BTC traded).

The second strategy would be to enter a position in the opposite direction (as contrarian effects are found for abnormally bullish price action in bitcoin) at the start of the next daily session.

This means we would have entered a short position around $9,214.50 and close the position at, or after, 16:00. If you closed the position at exactly 17:00 at a price ~$9,195, the profit would have only been around $20 per BTC traded — not that great.

But by 20:00, bitcoin had touched lows just below $9,000, so if you had tried to time to bottom and did so successfully you would’ve been slightly more profitable at around $200 profit per BTC traded.

In total, following these two simple strategies would’ve earned about $720-$900 profit per BTC traded. After trading fees, possible slippage and room for mis-timed entries, that might be reduced somewhat.

Trading Negative Overreaction Days

Let’s look at a negative overreaction day for BTC, using September 24 as an example.

Unusually bearish days are usually discovered after 16:00. Therefore, we could compare the cumulative abnormal returns for the day on an hourly basis and see that it has been decreasing throughout the day.

However, in this example, the price moves were contained to the later end of the day and at 16:00 it may not have been detected that bitcoin was experiencing a non-typical day.

By 19:00 it should have been clear with the large downward move. So we would have entered a short at 19:00 at a price of $8,639 and held until the end of the day. As the daily close was $8,541, this trade would have generated a profit of roughly $100 for each BTC traded.

Trading bitcoin on a negative overreaction day, timings are highlighted by the vertical blue lines

The other strategy would be to enter a short position on the open of the next daily candle and hold this position until at least 11:00. The market opened at $8,538 on September 25. If you closed the position at mid-day when the price was $8,340, you would have realised a profit of around $200 per BTC traded.

Following these two simple strategies would have generated around $300 per BTC traded, and slightly less if we accounted for trading fees, possible slippage, and leaving room for errors. Remember, since the paper’s results are based on historical price action between 2017 and 2019, extrapolating these results may not deliver the same results.

As the examples above show, days of abnormal price action for the largest cryptocurrencies can open up profitable opportunities. Investors can take advantage of this with two simple trading strategies:

Go with the flow once an exaggerated price move is detected and close the position at the end of the day. Go with the flow again on the open of the next daily trading session after a non-typical day (except for BTC-USD on a positive overreaction day and ETH-USD on a negative overreaction day, in which case you take a contrarian position). To close the position, use the timings depending on the direction and which coin you are trading.

Want to try out these strategies for yourself?

Head over to Interdax, the competitive cryptocurrency trading platform, to trade our bitcoin perpetual contract and take advantage of these trading strategies on days where the price moves disproportionately.

The full study ‘Momentum Effects in the Cryptocurrency Market After One-Day Abnormal Returns’ can be accessed here.

Disclaimer: This article is for informational purposes only. Do your own research before trading cryptocurrency and ensure you never risk more than you can afford to lose.