How to make money using momentum | stockbee


How to make money using momentum

Momentum investing looks for stocks rising faster than the overall market. Or in simple language it looks to buy strength and sell weakness.
Momentum has been extensively studied and studies show that stocks with the best price performance over the previous 3-12 month period tend to continue to outperform the market over the subsequent 3-12 month period while previous losers tend to continue underperforming. The most celebrated study in the academic literature which documented this phenomenon was by Jegadeesh Narasimhan and Sheridian Titman in a study titled "Returns of buying winners and selling losers
Jegadeesh, Narasimhan & Titman, Sheridan, 1993. " Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,Journal of Finance, American Finance Association, vol. 48(1), pages 65-91, March.
This paper documents that strategies that buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over three- to twelve-month holding periods. The authors find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnorm al returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented.
Since then this phenomenon has been studied in detail and it has been shown that this works across markets and is persistent in spite of it being known to market participants for years. General belief in market is if things are known they stop working.
In simple terms what these studies did was to take the entire universe of stocks in a given market and calculate returns over last 3 or 6 or 12 month period for all stocks. Then they ranked this stock universe by returns and separated 10 groups ranked by returns A zero cost portfolio of the top 10% stocks was created and held for 3 or 6 or 12 months and returns studied over the years. They found that the returns of the portfolio of top 10% stock was higher than that of next 10 to 20% and the return of next 10 to 20% was higher than 20 to 30% and so on for given holding period and the last group of stock in ranking had negative return. The top 10% stocks portfolio outperformed in returns in next 3 or 6 or 12 months over all the rest of the stock. Research also shows that this trend reverses after a 2-3 year holding period. Research also shows that in the shorter holding periods of 1 month, past 1 month winners do not show this tendency.
Top Research Papers About Momentum
  1. CHAN, L., N. JEGADEESH and J. LAKONISHOK, 1996. Momentum Strategies. NBER Working Paper. Cited by 297
  2. GRINBLATT, M., S. TITMAN and R. WERMERS, 1995. Momentum investment strategies, portfolio performance, and herding: A study of mutual fund behavior. American Economic Review. Cited by 255
  3. HONG, H. and J.C. STEIN, 1999. A unified theory of underreaction, momentum trading and overreaction in asset markets. The Journal of Finance. Cited by 363
  4. ROUWENHORST, K.G., 1998. International Momentum Strategies. The Journal of Finance. Cited by 216
  5. JEGADEESH, N., S. TITMAN and M.P. PAGE, 2001. Profitability of Momentum Strategies: An Evaluation of Alternative Explanations. The Journal of Finance. Cited by 193
  6. HONG, H., et al., 2000. Bad news travels slowly: size, analyst coverage, and the profitability of momentum strategies. The Journal of Finance. Cited by 214
  7. LEE, C.M.C. and B. SWAMINATHAN, 2000. Price momentum and trading volume. The Journal of Finance.Cited by 162
  8. MOSKOWITZ, T.J. and M. GRINBLATT, 1999. Do Industries Explain Momentum?. The Journal of Finance.Cited by 163
  9. GRUNDY, B.D. and J.S. MARTIN, 2001. Understanding the nature of the risks and the source of the rewards to momentum investing. Review of Financial Studies. Cited by 126
  10. LIEW, J. and M. VASSALOU, 2000. Can book-to-market, size and momentum be risk factors that predict economic growth. Journal of Financial Economics. Cited by 122
In simple terms what we know from these various studies is that:
  1. Stocks exhibiting 3-6-12 month momentum are likely to outperform in subsequent 3-6-12 month period.
  2. 1 month momentum tends to lead to reversal.
  3. Longer term momentum of 2-3 years also tend to lead to reversal.
  4. Momentum effect is more pronounced for small capitalization stocks.
  5. Studies also show sector momentum works in similar manner to stock momentum.
Besides the academic world actual market practitioners have also studied momentum based strategies and found that momentum based strategies work. In next part we will look at some of these researches

Valuation does not guarantee price, which is what we are trying to forecast. More often, valuation is a measure of risk level. Price, as many of us , learned in Economics 101, is determined by the laws of supply and demand which are in turn bounded by the human emotion of fear and greed! What's unique about price momentum based ranking system that no other variable claim, is that price cannot diverge from itself. Valuation, earnings estimates, economic fundamentals all have potential to move in the opposite direction of price, but price cannot diverge from itself. As a result, price momentum based ranking systems will lock on to the correct side of the trends. They also tend to get us out after a modest drawdown, thereby allowing profits to run while losses are cut short.
Being Right Or Making Money by Ned Davis Research (Retails on Amazon for $799 for the hardcover and $249 for the softcover).
Ned Davis is one of the most respected analyst on the street commanding huge following amongst institutional clients. Many years ago his firm published the above book and it was updated in 2000, just prior to 2000 market top. There is a reason the book is so much in demand. It details the methodology used by the firm to do top down analysis. It details various macro economics, sentiment, technical, financial, and inter market indicators used by his firm to arrive at timing model. If you want to become real "Big Picture" macro analyst, this book is a must read.
Now more important than the excellent macro indicators and their interpretation is their equity selection model. "Price Momentum Based Equity Selection (The General Theory of Relativity)", that is the title of the chapter which details the equity selection method.
The equity selection method uses one year relative strength. It uses a one year ROC to rank stocks. Then buys the top ranked 5% stock with strongest momentum and holds them until they fall below the top 10% in momentum rank.

The Quest for the Most Reliable Indicator in the World By Marke Boucher - The Hedge Fund Edge
"In the mid- to late-1980s, I was involved in a large research project with Stanford Ph.D., Tom Johnson and his graduate students. Our objective was very similar to what every trader is obsessed with today: We wanted to determine which tools actually made money in stocks, bonds, currencies and futures.I am pleased to report that we found what we were searching for.
We measured the performance of all indicators that had results we could easily measure. These included: PEs, P/Ss, volume accumulation, volatility, trend-following tools, earnings models, earnings growth and momentum, growth rates of earnings, projected earnings growth, value compared to earnings growth, chart patterns, pace of fund accumulation of the stock, capitalization—you name it.
Of all the independent variables we tested, Relative Strength (RS) was the most consistent, reliable and robust. It single-handedly improved profit better than anything else we tested.
The bottom line is this: If you’re looking for the most rigorous tool to help you pick the top-performing stocks. . .
. . .Relative Strength is it."

The real key is to make momentum work for you. Between the research and actually making it work is the process gap. You have to make it work in day to day trading. On the members site I have demonstrated various ways to trade momentum using Telechart scans and in the past few years shown in real time how momentum can be traded to beat the market.
Momentum is a structural edge and if you devote time and effort to understand the nuances involved in trading momentum, then you can gun for explosive returns. 

Related post:

Making momentum work

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FX Crusader. said...

what is the best way to measure relative strength ?

Pradeep Bonde said...

There is no one best way. There are many ways to measure relative strength. Each of the method has advantages and disadvantages.

Relative Strength is basically a velocity calculation. Velocity deals with rate of change. To calculate Rate of Change (ROC) we need two prices:

Price in earlier point in time
Price in later point in time
ROC = [(Number at later time ÷ Number at earlier time) - 1] × 100

So to calculate a 3 month ROC for a stock today we need:

Price 3 month ago
Price today
Mathematically ROC in this case is then:

[(Price today ÷ Price 3 month ago) - 1] × 100

You can calculate relative strength using moving averages, ratio of moving averages, as front or back weighted ROC, or ROC from low point and in many ways.

I have detailed many of these ways to calculate relative strength on members site.

Rakshit Shah said...

Hi Pradeep,

Great post and very informative and good summation on Relative Strength Comparison. Just a quick question - as you mentioned in the post, one month winners don't have the tendency to outpeform going forward (based on theoretical research). In such a case, wouldn't looking for stocks up 25% in one month be a little redundant. I am referring to couple of your recent posts where you emphasize the importance of looking for stocks that are up 25% in one month and then studying them to find reasons and setups.



Pradeep Bonde said...

The study of stocks up 25% plus in a month is to find those stocks at the beginning of their move as they are making 25% move and not for buying them after the move.

B7 said...

Wow, what an awesome resource for papers. Thank you!