Factor Investing: The Momentum Vector
Pitfalls of Momentum Trading
The “momentum” or the “mo” vector is the velocity of price changes in any tradable asset like equities. Mathematically speaking, it is the first derivative of the price changes with respect to time and helps investors understand trend signals.
Investors use the momentum vector to understand which trend a security falls in and then determine whether to go bullish or bearish. Identifying momentum trends can be done in many ways, but here two widely accepted methods:
- One, as the second derivative of price changes over time (or the rate of change of price velocity)
- Two, as the first derivative of momentum, also known as price acceleration or deceleration.
Note that momentum is deemed to be stalling if this factor is decreasing and rising if the factor is increasing. Strictly speaking, “mo” investing appears less like investing and more like trading. The notion of selling losers and buying winners is seductive, and employs the “buy high, sell higher” mantra. However, it flies in the face of the tried and true Wall Street adage, “buy low, sell high.”
In behavioral finance, a “mo” investor preys on the ‘herd’ mentality of ‘weak hands’ in the market who seems to suffer from a perennial case of ‘FOMO’. Momentum investors typically get in early, ride the FOMO wave and exit while others are still trying to get into the trade through the same door.
Pitfalls of Momentum Trading
Risks of momentum trading include moving into a position too early, closing out too late, and getting distracted and missing key trends and technical deviations. You can’t time the market perfectly at all time, and “mo” investors are at a significant risk to lose their shirts while implementing this strategy. As market participants, we have to be aware of this factor and therefore, have a hedging strategy in place to minimize drawdowns.
For the last decade plus, easy Fed policy has meant that the momentum behind equities has kept on rising. Even the pandemic did nothing to stop the meteoric rise in stock prices. But what goes up has to come down right? The question is, how do you identify the end of a momentum trend and how do you hedge this perceived risk in your portfolio. A few tenets:
- Position Management: Go big and you will go home. Size appropriately, maybe 5-7% of the portfolio as a max.
- Tight Risk Controls: Close a losing position, coz “mo” cuts both ways. Avoid riding the momentum train the wrong way down the tracks.
- The Hedge: We at 99rises calculate momentum for each stock within each block. Depending on a user’s risk score, a personalized hedge (e.g. a short) protects momentum draw-downs for our clients.
Momentum is a great indicator for identifying trends. However, it is more of a reflection of market sentiment and sometimes loses sight of fundamentals.
How We Create Sophisticated Hedge Fund Portfolios: We at 99rises use momentum as merely one of the many factors in our multi-factor model while creating portfolio blocks while superimposing a host of other factors in stock selection and portfolio construction.