Avoiding momentum crashes: Dynamic momentum and contrarian trading

Abstract

High momentum returns cannot be explained by risk factors, but they are negatively skewed and subject to occasional severe crashes. I explore the timing of momentum crashes and show that momentum strategies tend to crash in 1-3 months after the local stock market plunge. Next, I propose a simple dynamic trading strategy which coincides with the standard momentum strategy in calm times, but switches to the opposite contrarian strategy after a market crash and keeps the contrarian position for three months, after which it reverts back to the momentum position. The dynamic momentum strategy turns all major momentum crashes into gains and yields an average return, which is about 1.5 times as high as the standard momentum return. The dynamic momentum returns are positively skewed and not exposed to risk factors, have high Sharpe ratio and alpha, persist in different time periods and geographical markets around the globe.

Risk-Managed Momentum: An Evidence from Indian Stock Market

“…The present research thoroughly examines the relative momentum portfolios and finds that disappointing performance of loser portfolios (short positions) at times of market recovery causes momentum crashes. These findings support the existing literature on momentum crashes (Dobrynskaya, 2019;Fan et al, 2018). Therefore, the present study works on the positions aspect of relative momentum to avoid these crashes.…”

“…More recently, many academic studies report the crash risks associated with conventional momentum strategies (Barroso & Maio, 2019;Barroso & Santa-Clara, 2015;Chabot et al, 2014;Daniel & Moskowitz, 2016;Dobrynskaya, 2015Dobrynskaya, , 2019Fan et al, 2018;Gaunt, 2016;Grobys et al, 2018;Moreira & Muir, 2017; ). Barroso and Santa-Clara reveal that relative momentum delivers a return of −73.42% in just two months of the year 2009.…”

“…Nevertheless, relative momentum payoffs suffer from 'extreme downside risk' (Daniel & Moskowitz, 2016;Han et al, 2016). These payoffs are prone to crash occasionally (Barroso & Santa-Clara, 2015;Dobrynskaya, 2019). These rare crashes can eradicate the returns of several years.…”

“…These frameworks are based on either volatility scaling or the idiosyncratic component of asset returns. Implementation of these frameworks requires additional complex estimations or extra capital (Dobrynskaya, 2019). Therefore, the study's main objective is to propose a novel risk-managed momentum that is easy to implement and requires minimal estimations.…”

“…MiscellaneousJacobs et al, 2016;Han et al, 2016;Dobrynskaya, 2019;Singh et al, 2020 • Most of these approaches involve the computation of complex estimations.…”