Anatomy of a Momentum Strategy

#1
For the past couple of years, I have been trying to crack an ideal momentum strategy that would give the best risk/reward profile. I read a lot of books & research papers, conducted backtests, paper traded, as well as live traded. Below are my observations.

How to measure momentum - Classically ROC is used and it works just fine. One can also use regression (linear or exponential) to measure slope and fit.

Time frame & false signals - Shorter the timeframe to measure momentum, more the false signals. Momentum strategies work best when your look-back period is large. Most academic paper look at 12 months (leaving the latest month to account for short term reversal) and my observation is anything from 3-months to 12-months can work.

Control for volatility - extremely high volatility stocks can fall just as fast leading to earth-shattering drawdowns. 2 ways to control - avoid super high ADX stocks (>50) or avoid stocks with linear regression fit less than 0.6 or 0.7. Yes, you will miss out on some crazy returns but will control DD massively

Stocks to avoid - stocks which keep circuiting. They are a time bomb waiting to explode. They look great in backtests but try exiting a lower-circuiting stock and you'll know the problem.

When to enter - One can wait for a slight oversold(RSI(3) < 50) condition to make an entry or just enter on signal. My personal experience has been that trying time a momentum stock leads to more lost opportunities than downside protection.

When to exit - Stop losses are a suicide in a momentum strategy. This may sound controversial but let me explain. The returns curve of a momentum strategy by nature is a right-skewed. This means, traded long enough you will have a lot of trades with small losses and very few trades with extremely high gains (100%+). These few large gains are by nature high volatile stocks. Now if you apply stop loss, you'll exit these super profitable trades on which the entire strategy relies to make a lot of money.

Market Regime filter - It may sound silly but the number 1 requirement for momentum is 'momentum'. Unless the market is trending, you will not make money with the strategy. A classic filter is Nifty being above its 200-day MA (there are a few variations to this). I personally use 75-day MA since I am not comfortable with 30%+ DD. Typically, you'll be in market only 50% of the time over 5-10 year period.

Positions - Anything between 10 to 20.

Position sizing - The difference between equal size and risk parity positioning is not so great. This has been proved by research as well (Jagdeesh, Titman et. al.)

Measuring success - Sharpe ratio is not a good measure because of large positive standard deviation. An ideal measure can be CAR/MaxDD - a value above 1 should be great.

Strategies I have backtested/traded -
1. Stocks on the Move by Andreas Clenow
2. Quantitative Momentum by Wesley Gray
3. The 30-min stock trader by Lawrense Bensdorp

Would love to get more recommendation on books

If someone has traded on lower time-frames successfully, please do share ( I have been breaking my head for a long time on this)

P.S. Backtesting done on Amibroker. Survivorship Bias not accounted for.
 

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