Momentum / trend-following strategy

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myriam2222

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In the chapter of managed futures, there are a lot of references to momentum or otherwise called trend-following strategies.
What does it mean in practice? Does it mean for example that if you see a bubble, you will go for it instead of avoiding it / going short, even if you see a mispricing (overpricing in this case)? And you would try to sell before the others start doing it then?
Just trying to figure out concretely what such a strategy could mean.
Thanks
 
In practice momentum and trend following are two different ideas, albeit similar and often ocurr simultaneously. I don’t know if the book makes a clear disctinction between the two but keep this in mind:
1) Momentum trading is a trade where prices are increasing/decreasing and an increasing rate usually confirmed by heavy volume. Like you said, this can often be at the top of a bubble or nearing a bottom of a crash but not necessarily. It may also occur when trend trading is violated (switching directions or a new trend emerging)
2) Trend following is a trade where one could draw a disctinct linear line in a chart (up or down at some angle). Being able to draw a line into the future would be your projected ‘trend’ target. You could buy now and say “the trend is up, in 365 days the S&P 500 will trade at 2,xxx based on the trend we’ve seen in the past 18 months.”
 
I’ll try to answer my own question because I just read something that gave me a clue:
A trend-following strategy tries to add value by reacting to available information faster than the market or taking advantage of the fact that the market sometimes underreacts to certain information and does not sufficiently incorporate the new information in the stock price.
Basically, the market is on its way to adjust the price to all available information but because it takes too much time, the managed futures may benefit from being a first mover.
Is that correct? Do you guys have other wording suggestions? I would like to be able to reword these concepts in a manner that I am comfortable with.
thanks!
 
Galli wrote:
1) Momentum trading is a trade where prices are increasing/decreasing and an increasing rate usually confirmed by heavy volume. Like you said, this can often be at the top of a bubble or nearing a bottom of a crash but not necessarily. It may also occur when trend trading is violated (switching directions or a new trend emerging)
Click to expand...
ok thanks Galli.
Is the idea that, given high volumes, we expect the momentum to continue for some time and we just join the movement?
Does my last post make any sense and does it related to momentum trading then?
 
myriam,
Your wording sounds correct. Keep in mind that momentum trading (mo-mo trading) builds on an existing trend. Without a trend, there won’t be momentum. Trend traders are generally concerned with characteristics of the trend e.g. is the trend up or down, how long are we into this trend, what price targets are we likely to hit, and will use technical analysis tools to analyze a visible trend. Mo-mo traders are only concerned with how “hot” a particular stock (usually stocks) is and whether he/she can get in and get out with a quick profit (so long as the momentum is in tact or building). Practically, when you see increasing price as well as increasing volume action, that would indicate the stock is trading “hot” and will likely draw in more interested buyers (or suckers).
Also, think about this like a snowball rolling. A trend trader will say, hey, this snow ball is doing from point A to point B, so I think I can ride this trend. A mo-mo trader will say, dang, this snowball is getting mighty big and rolling mighty fast and there is no stopping it. As more traders pile in (both trend traders and mo-mo traders; same difference here), I will join in on the fun and get out when I have a profit (as opposed to a trend trader saying, hey, I think I will get off at point B). Mo-mo traders tend to be highly emotional and change their mind whenever they see the snowball rolling more slowly (decreasing momentum). When a price shake-out occurs (correction), mo-mo traders are the first to bail. Trend traders tend to be more patient and can stomach a paper loss so long as the perceived trend is not “broken.” Yes, they draw pretty lines on charts to convince themselves that the trend is still in tact. However, trend traders can be easily defeated by market makers purposely taking down a stock to a level that seemingly violates a well-known trend (stop hunting) and then woosh…pulls up the stock after the trend traders have been shaken out (similar to mo-mo traders although again, trend traders tend to have more patience and stick to a pre-determined strategy).
Does this make sense?
 
Thanks so much! Yes it makes a lot of sense and it was good that you used some metaphors because I am trying to get used to these concepts so I am reading you guys’ posts several times until I get really accustomed to them.
I will read them again from time to time :)
PS: is mo-mo an onomatopoeia to say that momentum traders act like cattle?
 
Nope, that would be moo-moo trading :)
I’ve head jokes about monkeys doing better trades than many human beings. Perhaps cows can trade too. We just need a “buy” input and a “sell” input.
Moo = BUY
Moo-Moo = SELL
 
I think you are onto something here. After all, trading can, at times, be such bovine or feline or pure monkey business…depending on the market or more precisely volatility environment you are in (these days, the interest rate environment, currency exchange rate environnent, words coming out of the mouths of the Super Mario Bros and Janet Mo Money Yellen all contribute to market volatility). Other times, either time-tested trend-following or mean-reversion strategies win out.
In all seriousness, the different classes of trading strategies can usually generate significant alphas during specific phases of the market, but just not during all phases of the market. Sometimes you gotta use a hammer to do a job best done by a hammer and sometimes you gotta use a screwdriver to do a job best done by a screwdriver, and other times…well you might as well go with a cow, a cat, or a monkey. Market volatility usually makes the determination on which strategies win. So if some smarty pants trader/portfolio manager ever comes to you with a “revolutionary idea” that can make you big bucks forever and ever…better turn him around and give him a boot in the @ss. Usually, they’ve just came out with a bigger hammer that bangs the loudest in a time period when hammers are the preferred tool…and as he hammers out more profits and attracts more capital…he gets more confident…just in time for his “first” real losing year when he should’ve switched to using a screwdriver instead (and it will be his biggest losing year). That’s why there is such a big survivorship bias in the hedge fund world. You see managers who win 10 in a row betting nickels and dimes only to have his “first” loss when betting real bucks that are not his.
So even the smartest guys get burned sometimes, and Murphy’s Law dictates that it’s usually at the worst possible time. With the all-star investment team at LTCM, their confidence in the form of leverage got to the best of them and Long-Term Capital Management turned into Short-Term Capital Management (still, what an awesome run while it lasted).
I am always amazed by how awesome the runs can get only to be followed by the even more dramatic bust that ends in tears, and I don’t think the cycle will ever stop so long as human beings rule the planet. Records are meant to be broken and I suppose we here all aim to cast our name in stone in some way or form so that we don’t end up irrelevant or forgotten (even better to do so before one gets old). In my recent memory, Citadel’s stat arb group pulled down 40% ($1B dollars) in 2008 when everybody and their mother lost a nice chunk of change to Mr. Market (401Ks became 201Ks). Talk about using the right tool for the right job at the right time. Since then, Miaw Miaw has done pretty well.
I hope this is relaxing to read as it was for me to write. Now I can work on a few more CFA Level III problems.
 
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