Momentum is arguably the most well-known trading strategy. Influenza A virus subtype H5N1 elementary strategy of buying stocks that receive got done good over the past times half dozen months ("winners"), in addition to shorting stocks that receive got done badly ("losers"), earns a 1%/month provide over the adjacent half dozen months. While other trading strategies halt beingness profitable ane time they receive got been discovered (because investors start exploiting them, removing the turn a profit opportunity), momentum has remained surprisingly lucrative e'er since Jegadeesh in addition to Titman (1993) get-go documented it.
A momentum strategy is attractive because it is market-neutral - since you're buying around shares in addition to shorting others, it tin dismiss brand coin inwards upwards markets in addition to downward markets. Thus, it is relatively immune to marketplace risk. The Sharpe Ratio (a stair out of the risk-adjusted provide to a trading strategy) of momentum is near 0.6, compared to 0.3-0.4 for merely belongings the market. I endeavor to exploit momentum myself, through the AQR Momentum ETF (ticker AMOMX).
Momentum is too pervasive - it industrial plant non exclusively inwards stocks, but too bonds, commodities in addition to telephone commutation rates equally shown past times Asness, Moskowitz, in addition to Pedersen (2013). That nosotros come across it inwards in addition to so many assets suggests that momentum is due to investors making mistakes - popularized past times a branch of enquiry known equally "behavioral finance". The top dog psychological explanation is that investors are boring to react to data - thus, proficient tidings takes fourth dimension to endure incorporated inwards prices, in addition to ditto for bad news.
However, fifty-fifty though the momentum strategy does good on average, at that topographic point are around periods where it does rattling badly, such equally inwards the recent hedge fund crisis - around hedge funds went nether because they followed momentum strategies that tanked. For example, betwixt March in addition to May 2009, the "losers" generated 163% returns, but the "winners" generated exclusively 8% returns. Thus, a momentum strategy is somewhat similar selling options - it makes coin on average, but sometimes does actually badly.
This novel paper by Kent Daniel of Columbia GSB, a onetime Managing Director inwards Sachs Asset Management in addition to Toby Moskowitz of Chicago Booth, a onetime winner of the Fischer Black Prize for outstanding contributions to finance enquiry past times somebody nether 40, shows yous when to move out of momentum strategies - in addition to so how to brand momentum fifty-fifty to a greater extent than profitable.
The answer is surprisingly elementary - move out of the momentum strategy inwards times of marketplace stress, when 1) the marketplace has late declined, in addition to 2) marketplace volatility (measured past times the VIX volatility index) is high. Here's a elementary intuition. If the marketplace has late declined, the "loser" portfolio must receive got declined much faster than the broader market. Thus, it has a high beta (= sensitivity to the market). The "winner" portfolio has a relatively depression beta, which is why it didn't spend upwards in addition to so much. After times of marketplace stress, the marketplace typically recovers. Thus, the "loser" portfolio, which has high beta stocks that are sensitive to the market, does peculiarly good inwards the marketplace recovery, in addition to and so yous desire to move out of the momentum strategy. Kent in addition to Toby notice that this surprisingly elementary enhancement to the momentum strategy doubles the Sharpe ratio from 0.6 to 1.2.
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