Cross-Sectional Momentum Trading

We will discuss an important momentum strategy that traders can deploy, named as Cross-Sectional Momentum Trading Strategy.

All the concepts covered in this email are taken from the Quantra course on Momentum Trading Strategies. You can take a Free Preview of the course and learn all these concepts in detail.  

 

Note: The links in this email will be accessible only after logging into quantra.quantinsti.com 

Have you ever noticed how some stocks seem to gather momentum and surge ahead, while others struggle to keep up? Well, that's the intriguing world of momentum trading. Momentum trading is a popular strategy in the financial markets that capitalises on the idea that stocks with strong recent performance are likely to continue their upward (or downward) trajectory in the near term.

 

What is cross-sectional momentum trading? It's all about how certain stocks just keep soaring while others keep struggling. This strategy focuses on identifying and taking advantage of stocks that consistently outperform their peers when it comes to price performance.

 

Let's take a look at a popular example: Apple and Microsoft. These two tech giants have been on fire in terms of their stock prices for quite some time. Apple's stock has been on a steady upward trajectory, with impressive relative gains year after year. Microsoft's stock has also been performing well.

 

Traders who practise cross-sectional momentum trading would spot these winning stocks, like Apple and Microsoft, and try to ride their upward momentum. They might buy these stocks or go long on them, hoping to benefit from their continued price outperformance.

 

The idea behind cross-sectional momentum trading is that stocks that have been winners in the past are likely to continue their winning streak in the future. By focusing on these outperformers, traders aim to enhance their portfolio returns and capture the benefits of their ongoing success.

 

So, in a nutshell, cross-sectional momentum trading is about identifying those stocks that just keep climbing higher and taking advantage of their price performance. It's like being on the winning team and enjoying the rewards.

 

In our discussion on cross-sectional momentum trading, we will cover the following:

• Exploring the factors that determine an effective lookback period, which helps in evaluating the relative performance of the securities.
• Taking a closer look at the key steps involved in implementing the strategy.
• Understanding the potential benefits for investors seeking to enhance their portfolio returns.

 

The plot of the returns of this strategy generated on a portfolio of stocks is shown below. The Python code for the strategy can be previewed in Section 14, Unit 12 of the Momentum Trading Strategies course. It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.

 

Determining the Optimal Lookback Period 

In momentum trading, we measure the momentum using the past performance of securities over a fixed period of time. This fixed period of time is called the lookback period. Selecting the optimal lookback period is critical for cross-sectional momentum trading success. It allows us to identify and capture meaningful trends in relative performance, and we can determine which stocks have exhibited consistent upward or downward momentum. 

Do you know what's interesting? Different timeframes can have different effects on cross-sectional momentum trading. Short-term lookback periods, usually less than a month, may lead to mean reversion and disrupt momentum. And if we go too long, beyond a year, we might see unwanted return reversals. Instead, focus on intermediate-term lookback periods ranging from one to twelve months. They offer consistent returns without troublesome reversals. It's like finding the sweet spot for optimal cross-sectional momentum trading to maximise your success, it’s where the magic happens!

 

Crafting the Winning Portfolio

Building a successful cross-sectional momentum portfolio begins with filtering stocks based on a key criterion: daily turnover. Research reveals that stocks with higher turnover tend to generate greater momentum profits. To optimise your strategy, prioritise stocks exhibiting high daily turnover. By focusing on the top 100 stocks with the highest turnover, you include securities with the potential to deliver attractive returns. Get ready to craft a winning portfolio that puts the power of momentum to work for you!

 

Ranking and Selection Demystified

After filtering the universe of stocks, it's time for the ranking and selection process. This involves sorting the top 100 stocks based on their lookback period returns. The stocks with the highest returns form the top decile, commonly known as the winner portfolio, while the stocks with the lowest returns constitute the bottom decile, known as the loser portfolio. The intention is to go long on the winner portfolio, reflecting the securities expected to sustain their outperformance, and simultaneously go short on the loser portfolio, anticipating continued underperformance.

 

Portfolio Size and Considerations 

The number of stocks included in the portfolio is a crucial consideration. While the selection process is flexible, a portfolio of 20 stocks (10 long and 10 short) is commonly employed. The selection of this number strikes a balance between reducing the minimum capital required and minimising transaction costs while maintaining an optimal risk-reward ratio per position.

 

Long-Only Strategy

It is worth noting that cross-sectional momentum strategies often adopt a long-only approach due to the restrictions on short-selling imposed by many fund houses such as mutual funds and pension funds. While a long-only strategy may seem riskier during market downturns, it remains a viable option for investors seeking to participate in the upside potential of securities. However, it is essential to manage risk through proper diversification and position-sizing techniques.

 

The returns of deploying the Long-only strategy on a portfolio of stocks are shown below. The Python code for the strategy is available here.

 

It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.

Summary 

Cross-sectional momentum trading helps investors boost portfolio returns by capitalising on relative performance trends. It focuses on the top 100 stocks with high turnover, including those with the potential for attractive returns. This strategy involves going long on the top 10 stocks with the highest turnover and short on the bottom 10 stocks with the lowest turnover. While there are multiple nuances to consider, such as portfolio size and the implementation of a long-only strategy, cross-sectional momentum trading presents a compelling opportunity for those seeking to unlock the power of momentum in their investment approach.

Apart from cross-sectional momentum, there is another type of momentum called time-series momentum. To learn about this in detail, you can check out the Quantra course on Momentum Trading Strategies.

 

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IMPORTANT DISCLAIMER: This email is for educational purposes only and is not a solicitation or recommendation to buy or sell any securities. Investing in financial markets involves risks and you should seek the advice of a licensed financial advisor before making any investment decisions. Your investment decisions are solely your responsibility. The information provided is based on publicly available data and our own analysis, and we do not guarantee its accuracy or completeness. By no means is this communication sent as the licensed equity analysts or financial advisors and it should not be construed as professional advice or a recommendation to buy or sell any securities or any other kind of asset.