Momentum and Reversal Combined with Volatility Effect in Stocks

Momentum is a simple well-known trading strategy that buys stocks with the best returns over the past three to 12 months and sells stocks with the worst returns over the same horizon. Many tweaks to the basic momentum strategy have been published in academic papers. Momentum combined with a volatility effect is one such useful trick as research shows that momentum returns could be enhanced by using the most volatile stocks. An additional advantage of this approach is that it works very well within large cap stocks (it is well-known that momentum works better in a small cap universe; therefore, any trick which works within large caps is helpful).

Fundamental reason

Academic research postulates that the medium-term momentum is rationalized largely along the behavioral avenue. Gradual information diffusion and/or investor under-reaction leads to momentum (Chan, Jegadeesh and Lakonishok, 1996; and Hong, Lim and Stein, 2000). Some researchers shows that information uncertainty can intensify return continuations under the postulation that investors under-react more (due to overconfidence) when presented with vague information. Following this line of thinking, investors should see a stronger momentum in securities with greater information uncertainty such as in smaller stocks and stocks with higher volatility.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Monthly
Notes to Period of rebalancing
Number of traded instruments
1000
Notes to Number of traded instruments
more or less, it depends on investor's need for diversification
Complexity evaluation
Complex strategy
Notes to Complexity evaluation
Strategy complexity depends on number of stocks investor wishes to include into his/her portfolio, as strategy could be much simpler for execution if investor picks less stocks.
Financial instruments
stocks
Backtest period from source paper
1964-2009
Indicative performance
16.46%
Notes to Indicative performance
per annum, annualized (geometrically) monthly return 1.278% for long short portfolio, data from table 2 for large firms with high volatility for 6-month ranking and 6-month holding period
Estimated volatility
19.22%
Notes to Estimated volatility
estimated from t-statistic 5.352 from table 2
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.65

Keywords:

momentum, stock picking, volatility effect, momentum in stocks, equity long short

Simple trading strategy

The investment universe consists of NYSE, AMEX and NASDAQ stocks with prices higher than $5 per share. At the beginning of each month, the sample is divided into equal halves, at the size median, and only larger stocks are used. Then each month, realized returns and realized (annualized) volatilities are calculated for each stock for the past six months. One week (seven calendar days) prior to the beginning of each month is skipped to avoid biases due to microstructures. Stocks are then sorted into quintiles based on their realized past return and past volatility. The investor goes long on stocks from the highest performing quintile from the highest volatility group and short on stocks from the lowest performing quintile from the highest volatility group. Stocks are equally weighted and held for 6 months (therefore 1/6 of the portfolio is rebalanced every month).

Source Paper

Wei: Do Momentum and Reversals Coexist?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679464
Abstract:
The answer to the title question is "Yes." Examining stocks traded on the NYSE, AMEX and NASDAQ for the period of 1964 to 2009, this study discovers that, while momentum prevails among small stocks, momentum and reversals coexist among large stocks for a holding period of up to six months. The momentum/reversal divide is along the volatility dimension: Large-cap/low-volatility stocks exhibit reversals while large-cap/high-volatility stocks experience momentum. This new discovery cannot be fully rationalized with either risk-based or behavioral-based explanations.

Other Papers

Wei, Yang: Short-Term Momentum and Reversals in Large Stocks
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2029984
Abstract:
Using stocks traded on the NYSE, AMEX and NASDAQ for the period of 1964 to 2009, this study demonstrates that, while momentum prevails among small stocks, momentum and reversals coexist among large stocks for a holding period of up to six months. The momentum/reversal divide is along the volatility dimension: Large-cap/low-volatility stocks exhibit reversals while large-cap/high-volatility stocks experience momentum. Our finding is in sharp contrast with those in the existing literature which mostly documents and explains momentum and reversals for different horizons. As such, our study not only offers fresh, new empirical findings on cross-section return predictability but also poses a challenge to the existing theoretical paradigms that are tailored to sequential occurrence of momentum and reversals. Specifically, we contribute to the literature by 1) uncovering a new empirical regularity which explains why large stocks are generally associated with no or weak momentum in the short-term, and 2) advancing a theoretical model based on "moderated confidence" which can rationalize empirical findings such as the one in the current paper where underreaction and overreaction can occur simultaneously with the same investor.