Momentum Trading [Part 1 of 3]

By Dr. Bruce Vanstone BackgroundBruce Vanstone is Assistant Professor at Bond University in Australia. He completed his PhD in Computational Finance in 2006 and is a regular presenter and publisher of academic work on stockmarket trading systems. He teaches stockmarket trading courses at university, and consults to Porter Capital Management on the design of mechanical, rules-based trading systems. More information on Bruce's research and methods can be found at http://trading.it.bond.edu.au. Financial market volatility over the next few years is likely to cause more actively managed rules-based approaches to out-perform long-term trend-following systems. I have asked Bruce to write a series of articles based on his experiences with momentum trading. ~ Colin Twiggs Introduction The purpose of this 3-part series of articles is to provide information about the potential benefits of momentum investing. In this series, I will try and explain what momentum is, the potential returns available to momentum investors, and the way that Porter Capital combine mechanical, rules-based strategies with the momentum effect to deliver benefits to investors. The premier anomaly Since its initial discovery by DeBondt & Thaler in 1985[1], the momentum effect has been documented and researched in many markets worldwide. Many traders and investors would know of the academic notion of the efficient market, and the implication that this efficiency has on the ability of investors and traders to earn profits. What you may not be aware of is that the father of the efficient market hypothesis, Eugene Fama, refers to momentum as the premier unexplained anomaly[2]. In other words, the success of momentum based investing is regarded by many as an exception to the efficient market hypothesis. What is it? In its simplest terms, momentum refers to buying stocks which exhibit past overperformance. Research shows that stocks which have exhibited strong performance over some defined historical period, have a tendency to continue to exhibit strong performance for some number of future periods. It means that investors can potentially hitch a ride on strong momentum stocks. In part 2 of this series, I will use simulations to explore the potential risks and rewards of the momentum approach. A Typical Momentum Trade

The typical momentum trade has a history of clearly defined direction and strength. Figure 1 shows a chart of price activity for ALL (Aristocrat Leisure), from August 2004 to April 2005. During late August 2004, there is a clear price breakout on very heavy volume. This marks the start of the momentum opportunity. Over the next few months, the price activity demonstrates clearly defined direction.

Is it credible? The momentum effect has been widely researched and documented in both the international and Australian equity markets. For example, Rouwenhorst[3] tested momentum strategies in 12 European markets using data from 1980 to 1995, and found that momentum returns were present in every country, and their effects lasted for approximately one year. Griffin et al.[4] found support for the profitability of momentum investing in over 40 countries, and concluded Globally, momentum profits are large and statistically reliable in periods of both negative and positive economic growth. Momentum has been thoroughly researched in virtually all of the worlds equity markets. Momentum effects have also been documented in other asset classes, such as foreign currencies[5], commodities[6] and real estate[7]. It is fair to say that the momentum effect appears to be one of the most beneficial effects for investors. Thorough research appears to indicate that momentum based investment does not increase investment risk, and that momentum effects are present during both economically good and bad cycles.

When does it work best? Like all investment approaches, momentum investing is subject to the vagaries of the investor. For many investors, poor returns are not so much a function of their investment strategy, but of their own implementation of that strategy. All investment strategies benefit from the increased discipline and accountability that mechanical, rule-based trading brings, particularly during difficult investment cycles. I will discuss this topic in more detail in the third part of this momentum series. References

1. DeBondt, W.F.M. and R.H. Thaler, Does the stock market overreact? Journal of
Finance, 1985. 40: p. 793-805.

2. Fama, E. and K. French, Common Risk Factors in the Returns on Stocks and
Bonds. Journal of Financial Economics, 1993. 33(1).

3. Rouwenhorst, K.G., International Momentum Strategies. Journal of Finance,

1998. 53(1): p. 267-284.

4. Griffin, J.M., S. Ji, and J.S. Martin, Global Momentum Strategies: A Portfolio
Perspective. Available at: SSRN: http://ssrn.com/abstract=492804, 2004.

5. Okunev, J. and D. White, Do momentum-based strategies still work in foreign

currency markets? Journal of Financial and Quantitative Analysis, 2003. 38.

6. Taylor, S.J., Forecasting Market Prices. International Journal of Forecasting,

1998. 4: p. 421-426.

7. Stevenson, S., Momentum effects and mean reversion in real estate securities.
Journal of Real Estate, 2002. 23: p. 47-64.

How Socialism Works

I have been unable to trace the original source of this piece received via email. An economics professor at a local college made a statement that he had never failed a single student before, but had once failed an entire class. That class had insisted that socialism worked and that no one would be poor and no one would be rich, a great equalizer. The professor then said, "OK, we will have an experiment in this class......." All grades would be averaged and everyone would receive the same grade so no one would fail and no one would receive an A.

After the first test, the grades were averaged and everyone got a B. The students who studied hard were upset and the students who studied little were happy. As the second test rolled around, the students who studied little had studied even less and the ones who studied hard decided they wanted a free ride too so they studied little. The second test average was a D! No one was happy. When the 3rd test rolled around, the average was an F. The scores never increased as bickering, blame and name-calling all resulted in hard feelings and no one would study for the benefit of anyone else. All failed, to their great surprise, and the professor told them that socialism would also ultimately fail because when the reward is great, the effort to succeed is great but when government takes all the reward away, no one will try or want to succeed.

Development Plans
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Success demands singleness of purpose. ~ Vince Lombardi.

Introduction This article is part 2 of a 3-part series. In this article, I will focus on using simulations to demonstrate the potential risks and rewards of the momentum approach. In the final part of the series, I will discuss the way in which investors can benefit from rule-based approaches to investment. Creating Momentum Simulations The results presented in this article are a quick demonstration of the potential of the momentum effect for Australian investors. I like to use simulations as they provide an excellent opportunity to see how well a strategy could have performed in the past. Simulations are also useful because they can give some clues as to how a strategy may perform in the future. However, we must always remember that past performance is no guarantee of future performance. The simulation results in Table 1 have been created by calculating momentum on a historical rolling monthly basis for each member of the ASX200, and holding the top group of stocks each month. The data used contains delisted stocks, and is adjusted for survivorship bias as and where possible. Both simulations assume the same starting capital and account for transaction costs and slippage. The simulations cover the 10 year period from 2000 to 2009. Applying Simulations to the ASX200 Table 1: Simulations of the Momentum Effect for Australian Investors Historical Momentum Period 12 Risk (Max DD %) -60.07% Reward (APR%) 18.54% ASX200 benchmark Risk (Max DD%) -53.13% ASX200 benchmark Reward (APR%) 4.76%

The columns contained in the table are explained below: Historical Momentum Period Risk (Max DD%) Reward (APR%) ASX200 benchmark Risk (Max DD%) ASX200 benchmark Reward (APR%) The number of months over which historical momentum was measured Risk as measured by the maximum drawdown Reward as measured by APR (annual percentage rate) Risk as measured by the maximum drawdown in the equivalent benchmark (XJO) Reward as measured by APR in the equivalent benchmark (XJO)

Figure 1 shows an equity graph plotting a simulated portfolio versus the ASX200 (XJO) index portfolio.

Conclusions we can draw from this In the first article of this series, I pointed out that the momentum effect appears to be one of the most beneficial effects available to investors. The results in Table 1 and Figure 1 clearly confirm this observation. The results above also confirm that to capture the benefits of a momentum approach, investors do not need to trade frequently, or with huge sums of capital, or in highfrequency timeframes. Instead, what is required is a disciplined, rules-based approach to investment, and a strong focus on risk management. Although the momentum approach has slightly higher maximum drawdowns than the ASX200, the "potential" returns are substantially higher. Clearly though, investing using momentum alone is not a holy grail for investors! However, these results confirm that the momentum effect could be used to form the basis of an actively managed investment strategy, one that focused on trying to capture some of the outperformance, while still keeping an eye on risk. In the third part of this series, I will discuss the benefits to investors of mechanical, rules-based trading approaches. Many investors receive sub-standard investment returns, particularly when managing their own capital. In some cases, it is not the strategy itself, but the way it is being implemented which is at fault. If you find yourself attempting to second-guess the way you trade, or you are unsure how to react during periods of market turmoil, then it is likely that you could benefit from the increased discipline and accountability that mechanical approaches can deliver.

Ability is what you're capable of doing. Motivation determines what you do. Attitude determines how well you do it. ~ Lou Holtz.