From Marginal Evolution:
Momentum trading produces outsized losses, paper
Piling in on the hot stock can be all too exciting not just because of the exuberance from outsized gains but also because of the pain of outsized losses such trading strategy can bring and which one of these possibilities happens depends on when such trading strategy is employed, says the latest paper from a triplet of professors.
It has been well documented that price momentum strategy – long position in past winners and an equal short position in past loser – produces outsized gains but based on data from July 1927 to December 2010, authors Kent Daniel, Ravi Jagannathan and Soohun Kim, find that such strategy inflicts staggering losses suggesting that the strategy has a hidden bias in it.
“Given the low unconditional volatility of the momentum strategy, if returns were normal the probability of observing a month with a loss exceeding 42% in a sample of 1002 months would be one in 29,000, and the probability of seeing five or more months with losses exceeding 42% would be almost zero. Yet the lowest five monthly returns in the sample are: -79%, -60%, -46%, -44%, and -42%, a rare black swan like occurrence from the perspective of someone who believes that the time series of monthly momentum returns are generated from an i.i.d. normal distribution,” calculate the authors.
The authors then spend some time looking for a mathematical model that would capture these two states of events, and after some discussion they settle on the “two state hidden Markov model” – a jingo for breaking up the market into two characters: turbulent or calm.
Based on the 1002 months of data, the authors calculate that the “average duration of 16 months and turbulent months have an average duration of 4 months” and it is within these 4 months that these staggering losses occur....MORE