Crypto Illiquid Reversals
Large and liquid cryptocurrencies exhibit momentum. If they have gone up, they will continue doing so a little while longer. It turns out that the small and illiquid ones do just the opposite.
The problem
Plenty of evidence has found that the large cap, liquid cryptocurrencies exhibit a momentum effect, defined in the literature as the returns to “buying past winners and selling past losers” (Jegadeesh and Titman, 1993). However, when you test for this effect on a much wider pool of cryptocurrencies, an interesting effect emerges. The small and illiquid ones don’t exhibit this effect, they do just the opposite. Strong previous returns in one direction negatively predict the next day’s return.
The idea
Now, you might be thinking, who would even think to design a strategy which aims to extract an edge from illiquid and small cap cryptocurrencies? Are they not impossible to trade? And how do you short them? All of these are valid questions. And ones that caused several headaches.
Through perpetual futures, a type of derivative with no expiry date which requires periodic funding payments to converge to the spot price, we solve the shorting problem. The small and illiquid part is a feature, not a bug, so we will just have to deal with it.