Momentum trading: Following trends systematically.

The Power of Trends

Momentum is one of the most researched and robust phenomena in financial markets. Assets that have performed well tend to continue performing well; assets that have performed poorly tend to continue underperforming.

This observation challenges the efficient market hypothesis — if markets were perfectly efficient, past returns would have no predictive power for future returns. Yet momentum has persisted across markets and time periods.

The Academic Foundation

Jegadeesh and Titman (1993)

The seminal research on momentum came from Narasimhan Jegadeesh and Sheridan Titman. They studied U.S. stocks from 1965 to 1989 and found:

Their work launched decades of follow-up research.

Global Evidence

Subsequent studies found momentum works across:

Cliff Asness and AQR Capital have published extensively on momentum's persistence across global markets.

Why Momentum Exists

Several explanations have been proposed:

Behavioral Explanations

Underreaction

Investors process new information slowly. When a company reports good earnings, the price adjusts, but often not fully. The adjustment continues over weeks or months as more investors recognize the implications.

Overreaction and Herding

Once a trend becomes visible, investors pile in. Media coverage attracts more buyers. The trend extends beyond what fundamentals justify, but this creates profitable momentum along the way.

Disposition Effect

Investors tend to sell winners too early (to "lock in gains") and hold losers too long (hoping for recovery). This selling pressure on winners and reluctance to sell losers slows the adjustment of prices to fair value.

Structural Explanations

Institutional Constraints

Fund managers face career risk for deviating from benchmarks. This creates slow adjustment as institutions gradually shift allocations rather than making immediate changes.

Information Diffusion

News doesn't reach all investors simultaneously. Some react quickly; others take weeks to process and act. This staggered response creates trends.

Implementing Momentum Strategies

Basic Framework

A simple momentum strategy:

1. Rank assets by their past return (typically 3-12 months)
2. Buy the top performers (e.g., top decile or quartile)
3. Sell/Short the bottom performers
4. Rebalance periodically (weekly or monthly)

Lookback Period

The measurement period matters:

Most research finds 6-12 month lookback periods work best.

Holding Period

How long to hold momentum positions:

Avoiding the Reversal

Short-term returns (past month) often show reversal, not momentum. Many practitioners skip the most recent month when calculating momentum scores to avoid this effect.

The Risks

Momentum strategies can suffer severe drawdowns:

Momentum Crashes

When markets reverse sharply, momentum strategies can lose heavily. The worst historical drawdowns occurred during:

During these periods, momentum portfolios can lose 30-50% as previous losers suddenly become winners.

Crowding

As momentum strategies became popular, more capital chased the same trades. This potentially:

Transaction Costs

Momentum requires regular rebalancing, generating trading costs that can erode returns, especially for smaller accounts.

Momentum Across Asset Classes

Currency Momentum

Currency momentum strategies buy currencies with recent appreciation and sell those with depreciation. Research shows:

Commodity Momentum

Trend following in commodities has a long history:

Fixed Income

Bond momentum is more complex but exists:

Combining Momentum with Other Factors

Momentum works best in combination:

Momentum + Value

Value (buying cheap assets) and momentum are nearly uncorrelated. Combining them creates a smoother return stream.

Momentum + Quality

Adding quality screens (profitability, low leverage) to momentum portfolios improves risk-adjusted returns.

Multi-Asset Momentum

Applying momentum across stocks, bonds, commodities, and currencies diversifies the strategy and reduces asset-class-specific risk.

Systematic Implementation

The key advantage of momentum strategies is that they're fully systematic:

This makes momentum well-suited for algorithmic implementation. Systems like Cypher's Delorean can implement momentum-based approaches without the emotional interference that causes most traders to abandon strategies at the worst times.

Key Takeaways

1. Momentum is robust: Extensive research confirms its existence across markets and time periods
2. Behavioral and structural factors: Human biases and institutional constraints create trends
3. Crashes happen: Momentum can suffer severe drawdowns during market reversals
4. Combination improves: Momentum works best combined with other factors
5. Systematic execution: Rules-based implementation removes emotional interference

Sources:

Risk Disclosure: Trading involves substantial risk of loss. Past performance is not indicative of future results. Only trade with capital you can afford to lose.

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