Momentum Trading has been demonstrated to be one of the most consistent systematic trading systems in the markets. Not only is it highly appreciated by the practitioners, but there is also a large body of literature among researches acknowledging that momentum exists in markets and we believe can be exploited by an astute trader.
Early research started by Narasimhan Jegadeesh and Sheridan Titman in 1993 ( and developed by many others since then), reveal that historically momentum Investing has outperformed the market Index (S&P500) over long term . This is contrary to efficient-market hypothesis (EMH) which believes that financial markets are “information efficient”, which means that you cannot achieve returns in excess of the market in the long term.
In this article we are going to shed some light on the nature of momentum trading and it’s intricacies.
Momentum is defined as the speed of price change. It is the amount of points or percentage change achieved by a stock or currency in a given period. For example if a stock gains 5 dollars in 5 days, it will have a momentum of 5. Now if the same stock gains 4 dollars in the following 5 day period, it will have a momentum of 4 (notice that prices rose again in the second period, but at a reduced rate of momentum).
From a trading point of view, momentum can take one of two forms:
1. Cross Sectional Momentum
This is when traders implement set’s of comparison rules to identify the out-performers (those with higher momentum) and under-performers (those with lower momentum) in a given universe of stocks and/or financial securities. The theory is that out-performers/under-performers will keep on out-performing/under-performing in the near to medium term. Traders then establish portfolios buying outperforming financial instruments and shorting the under-performing ones.
Given the complicated nature of portfolio construction and the advanced mathematics required, for the purpose of this article we will not elaborate much further on cross sectional momentum. Instead we turn our attention to the second form of momentum which is known as Absolute Momentum.
2. Absolute Momentum (single time series momentum)
This is when traders look at the historical prices of a given security in a specific time frame (i.e. Hourly EURUSD) in order to find acceleration and deceleration phases of the market. The process usually involves comparing current prices to the prices x periods ago to work out the momentum and determine if a trend is going to emerge. In the case of an existing trend, momentum studies can be done to see if the trend is accelerating or is running out of steam.
Rate of Change (ROC), Relative Strength (RSI), Stochastics, Volume etc … are all popular momentum indicators used by traders. We would like to focus on the Rate of Change (ROC) also known as Momentum Indicator in some platforms. However you may want to explore some of the others and understand their individual uses.
ROC (N) is calculated as : Current Price/Price of N Periods ago.
For example if the current price is $12, and the price 10 periods ago was $8 then the ROC (10)= 12/8=1.5. From a trading point of view, we are mainly interested in the changes in ROC rather than it’s absolute value. The following, will discuss how and when ROC can be used in more detail.
One way to see if the current trend is going to continue is to see if ROC and prices are going in the same direction. A price increase with a rising ROC generally means there is increasing upward pressure in the market and long positions can be considered. Inversely, a price decrease with a declining ROC generally means there is increasing downward pressure in the market and short positions can be considered.
Where it gets interesting is when ROC and prices move in opposite direction. This is when ROC declines and prices continue to increase. In the trading world this is known as divergence. Divergence is usually a sign of exhaustion and indicates that markets are poised for a corrective move. In dealing with divergence, one should be extremely careful as divergence doesn’t immediately create a reversal. The reason is that markets can remain divergent for a considerable amount of time before they change direction (if they actually do). Therefore traders need to apply objective and tested rules to trade divergence.
The below chart is a daily EURUSD. Notice how the uptrend in price (blue arrow) was accompanied by the downtrend in momentum. Euro ended up changing direction after this divergence.
Sudden and extreme shifts in ROC, are usually an early warning sign that the trend is likely to change. Like divergence it develops ahead of trend changes and can be a great tool to help traders get ahead of a move.
To better understand this concept take a look at the following chart which shows an upward trend with rising momentum. In an upward trend, corrections (pullbacks) are a natural part of the cycle and create more buying opportunities. So seeing a corrective move alone does not imply that the trend is about to change (especially in this case where ROC is moving in the same direction of the trend).
However if you look at the last pullback shown by the blue arrow, you will notice that this pullback is accompanied by such a strong drop in momentum where the indicator reaches a six month low. This sudden extreme drop in ROC in an environment where the trend is still up signals that market pressure is quickly changing and one should be ready for a potential trend reversal.
Momentum setups like the above (along with many other forms) occur quite frequently, they just need to be defined correctly. One of the most common explanations for momentum is that it feeds on human behavioral patterns and bias. Whether you like it or not traders tend to react slower to new information than what computers do therefore this leads to an initial under-reaction and subsequent over reaction which then reinforces the current trend/momentum.
Investors are known to look at the current price movements and take them as a representative of future moves. This leads to moving money into sections of the market which have recently appreciated which will cause trends to continue.
We believe that momentum techniques are an important aspect in building robust trading systems. However just like with any system, it is extremely important to understand that a clear definition of trading thresholds and robust risk management is needed before implementing them in a live environment and we cannot stress this point enough.