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Momentum Strategies

Difficulty intermediate

Concept

Momentum is the tendency for assets that have performed well (poorly) to continue performing well (poorly). It's one of the most robust anomalies in finance.

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  └──────────────────────────────────────────────────────→ decile of    
   D1   D2   D3   D4   D5   D6   D7   D8   D9   D10   past-12m return   
   losers ←─────────────────────────────────────→ winners               

  cross-sectional momentum: long top decile, short bottom decile        
  the monotone slope is the empirical signature

Academic Foundation

  • Jegadeesh & Titman (1993): "Returns to Buying Winners and Selling Losers"
  • Cross-sectional momentum: 3-12 month lookback
  • Time-series momentum: Absolute returns predict future direction

Strategy 1: Cross-Sectional Momentum

1. Rank assets by past N-month returns
2. Go long top decile (winners)
3. Go short bottom decile (losers)
4. Rebalance monthly

Strategy 2: Time-Series Momentum

If asset return over lookback > 0 → Long
If asset return over lookback < 0 → Short/Flat

Strategy 3: Dual Momentum

1. Calculate absolute momentum (vs. cash/risk-free)
2. Calculate relative momentum (vs. benchmark)
3. Only invest if both are positive
4. Choose asset with highest relative momentum

Momentum Factors

Factor Lookback Rationale
Short-term reversal 1 month Overreaction correction
Medium-term momentum 3-12 months Underreaction to news
Long-term reversal 3-5 years Overreaction to trends

Momentum Crash Risk

Momentum strategies are prone to sudden crashes during market reversals:

2009 Momentum Crash: Value stocks rallied sharply, devastating momentum portfolios that were short value.

Mitigation: - Add trend filter - Use volatility targeting - Implement stop-losses - Diversify across asset classes

Momentum Indicators

Rate of Change (ROC)

ROC = (P_t - P_{t-n}) / P_{t-n} × 100

where: ROC rate of change (%) · P_t current price · P_{t-n} price n periods ago. does: percent return over a fixed lookback. Common momentum signal — high ROC ranks an asset as a winner for cross-sectional sorts.

Relative Strength

RS = Asset Return / Benchmark Return

where: RS relative strength ratio · Asset Return cumulative return on the asset · Benchmark Return cumulative return on the benchmark over the same window. does: measures outperformance vs. a reference index. Used to filter momentum candidates to those beating the market — the basis of IBD-style relative-strength rankings.

Momentum Oscillator

Momentum = P_t - P_{t-n}

where: P_t current price · P_{t-n} price n periods ago. does: raw price change over the lookback. Sign gives direction, magnitude scales by price level — prefer ROC for cross-asset comparison.

Combining Momentum with Other Factors

Combination Rationale
Momentum + Quality Momentum in high-quality stocks
Momentum + Low Vol Reduce momentum crash risk
Momentum + Value Avoid momentum in expensive stocks
Momentum + Size Small-cap momentum is stronger

Performance Characteristics

Metric Typical Range
Win Rate 45-55%
Profit Factor 1.3-2.0
Sharpe Ratio 0.5-1.2
Max Drawdown 15-40%
Avg Holding Period 1-6 months

Practical Guidelines

  1. Trend Filter — Only take momentum signals in trend direction
  2. Volatility Adjust — Scale positions by volatility
  3. Diversify — Across assets, sectors, timeframes
  4. Avoid Earnings — Close positions before earnings
  5. Rebalance Regularly — Monthly or quarterly
  6. Crash Protection — Have a plan for momentum crashes
  7. Patience — Momentum strategies underperform in mean-reverting markets

Next Steps