Momentum is hard to catch. It’s like when you want to go to a party, you arrive and you see a queue of people to get in, you think the party must be great and you pay a pretty expensive entrance to get through. Then you come in, you order a drink and three minutes later the music stops and the party’s over. And there you are, looking silly, seeing how many have had a very “good time” but finding that you’ve missed it.
With a momentum strategy, if you don’t manage it well, it’s pretty much the same. You enter the market with expensive prices and a stop-loss that is far away so that a few candles after the supposed trend is over. Then, in this article we will analyze this type of strategies, to be able to adjust our radar better and thus take advantage of the party as long as possible.
What Is a Momentum Strategy?
A momentum strategy is part of the set of trend strategies. Following a momentum strategy is basically investing (taking long positions) in those financial assets that are showing a clear increase in their price. Those assets that are strongly bullish are bought in hopes that this bullish fortress will continue. In momentum strategies, the strength of movement is the key.
When to Choose a Momentum Strategy
The theory is that all assets have their momentum, you just have to know how to catch it in time. Following the simile of the party, in a city there are several discotheques, but curiously there are only some that – for various reasons- are fashionable and is where there are more people. The fashionable discos take turns, the one that was fashionable last summer, this one is no longer fashionable, but maybe it will be fashionable again in three years. The idea is to be able to find out what the reasons are that make a disco fashionable, or that a financial asset begins to rise so that they can enter in time.
Similarly, going back to the world of investment, we can see that momentum is not a permanent effect. Its duration is limited in time. This forces us to evaluate and alternate the elements of a momentum portfolio on a regular basis.
Absolute Momentum and Relative Momentum
If you analyze the momentum you can distinguish two situations. On the one hand, we have the impulse of the asset for itself ( time-series momentum), and on the opposite side, the impulse of the asset with respect to other values ( relative momentum).
Time-Series Momentum: Autocorrelation in Time Series
The autocorrelation level in an asset tells us if its past and future profitability are correlated. Put simply: the idea is that today’s profitability is related to yesterday’s profitability. In this case, if the degree of autocorrelation is high, it can be interpreted that we can estimate future performance.
Cross-Sectional Momentum or Relative Momentum
In this case, what counts is the profitability plus when we compare different assets. The idea is that those shares or assets that have a higher relative return continue to maintain this advantage over time.
One type of momentum is independent of the other. We can find that an asset shows a positive relative momentum (it is stronger than the others), but nevertheless has an absolute negative momentum (it is in a bearish trend). Conversely, you can also give an asset a positive absolute momentum but still have a negative relative momentum as there are other assets that are rising even further.
How to Measure Momentum?
Do not confuse a momentum strategy with the Momentum indicator. You can use the Momentum indicator to follow a momentum strategy, but you can also use other indicators of technical analysis (such as RSI, ROC, moving averages, etc.) or directly the price analysis.
The Momentum Indicator
This indicator simply shows the price difference between the current candle and the N candle days ago. The value of the Momentum indicator is expressed in absolute terms ( how many € or USD of difference in the quotation). If you prefer to express this difference in relative terms, then use the ROC ( Rate of Change).
The graphical representation of the Momentum indicator is an oscillator that fluctuates around a 0-neutral line. In technical analysis, attention is often paid to the oscillator crossings with line 0 and to the divergences between the Momentum oscillator and the price.
Momentum Strategy Values
In general, a momentum strategy will have good results in assets showing trend behavior. For example raw materials, some currencies, low capitalization stocks… According to some studies, the momentum has a longer duration and impact on those actions with lower capitalization and a lower BTM ratio ( book to market).
One way to know if an asset has a trending behavior, and then it might be a good idea to apply a momentum strategy, is to do the test that is detailed in this entry “Tendencial or antitendential system Which one to choose? “
Advantages and Disadvantages of a Momentum Strategy
Momentum is not a permanent effect. It’s not some kind of “buy and hold” strategy. We have to assess the assets on a recurring basis and if necessary modify the items we have in the portfolio.
- Consequence 1: It is a strategy that needs regular attention.
- Consequence 2: Attention to commissions according to the broker you work with.
In the case of following a momentum strategy with actions, the key is in diversification and in managing the risk of each position (as an example you can see this Momentum System for trading with actions). You don’t have stable returns. Investing in momentum is a long-term strategy. In some years it works and in others, it doesn’t.
Examples of Momentum Strategies
A simple example is to use the RSI – relative strength index – to signal inputs and outputs. Now we see that the purchase is made at the time the RSI is greater than 70 and the position is closed when the RSI is less than 30.
This other strategy applies the logic of momentum to commodity futures, rebalancing the portfolio of futures once a month: Momentum Effect in Commodities. Use momentum indicator crosses: Purchase order when the momentum indicator cuts up the 0 line and sale when the indicator cuts down. Strategies of “Dual momentum” where the absolute moment is combined with the relative one.
How? in this case it is started by using a relative momentum strategy while avoiding assets with negative absolute return (comparing the difference in return of the asset with respect to short-term bonds).