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 show 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 stronger momentum in securities with greater information uncertainty such as in smaller stocks and stocks with higher volatility.

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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Strong

Backtest period from source paper
1964-2009

Notes to Confidence in Anomaly's Validity

Indicative Performance
16.46%

Period of Rebalancing
Monthly

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


Notes to Period of Rebalancing

Estimated Volatility
19.22%

Number of Traded Instruments
1000

Notes to Estimated Volatility

estimated from t-statistic 5.352 from table 2


Notes to Number of Traded Instruments

more or less, it depends on investor’s need for diversification


Maximum Drawdown

Complexity Evaluation
Complex strategy

Notes to Maximum drawdown

Notes to Complexity Evaluation

Sharpe Ratio
0.65

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 returns 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 six months (therefore, 1/6 of the portfolio is rebalanced every month).

Hedge for stocks during bear markets

Not known - Source and related research papers don’t offer insight into correlation structure of proposed trading strategy to equity market risk, therefore we do not know if this strategy can be used as a hedge/diversification during time of market crisis. Strategy is built as a long-short, but it can be split into 2 parts. Long leg of strategy is surely strongly correlated to equity market however short-only leg can be maybe used as a hedge during bad times. Rigorous backtest is however needed to determine return/risk characteristics and correlation.

Source paper
Wei: Do Momentum and Reversals Coexist?
- 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.

Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers
Wei, Yang: Short-Term Momentum and Reversals in Large Stocks
- 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.

Chiang, Kirby, Nie: Nonlinearity, Return Reversals, Information Flow, and the Idiosyncratic Volatility Puzzle
- Abstract

Stock returns display a robust cross-sectional relation with prior idiosyncratic volatility (IVOL). However, the relation is both nonlinear and non-monotonic. Because the relation is concave in nature, it is consistent with a positive price of volatility risk combined with a behavioral preference for high-volatility stocks on the part of some investors. The effect of prior IVOL is also heavily influenced by prior stock returns. It is negative for stocks that are big losers and positive for stocks that are big winners. Replacing IVOL with dollar trading volume produces similar findings. The strong similarities between the results for IVOL and those for trading volume suggests that IVOL acts as a proxy for the arrival rate of information that spurs speculative trading, and that the likelihood of return reversals falls as the relative importance of speculative trading increases.

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