The Illusory Nature of Momentum Profits

48 Pages Posted: 29 May 2003  

David A. Lesmond

Tulane University - A.B. Freeman School of Business

Michael J. Schill

University of Virginia ­ Darden School of Business

Chunsheng Zhou

Peking University - Guanghua School of Management - Finance

Abstract

In markets with trading friction, the incorporation of information into market prices can be substantially delayed through a weakening of the arbitrage process. We re-examine the profitability of relative-strength, or momentum, trading strategies (buying past strong performers and selling past weak performers). We find that standard relative-strength strategies require frequent trading in disproportionately high-cost securities so that trading costs prevent profitable strategy execution. In the cross section, we find that those stocks that generate large momentum returns are precisely those stocks with high trading costs. We conclude that the magnitude of the abnormal returns associated with these trading strategies creates an illusion of profit opportunity when, in fact, none exists.

Keywords: Trading Strategies, Momentum, Transaction Costs

JEL Classification: G14

Suggested Citation

Lesmond, David A. and Schill, Michael J. and Zhou, Chunsheng, The Illusory Nature of Momentum Profits. Journal of Financial Economics, Vol. 71, No. 2, pp. 349-380. Available at SSRN: https://ssrn.com/abstract=256926 or http://dx.doi.org/10.2139/ssrn.256926

David A. Lesmond

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
511 Goldring-Woldenberg Hall
New Orleans, LA 70118
United States
504-865-5665 (Phone)
504-865-6751 (Fax)

Michael J. Schill (Contact Author)

University of Virginia ­ Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4071 (Phone)
434-243-7676 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/schill.htm

Chunsheng Zhou

Peking University - Guanghua School of Management - Finance ( email )

Beijing, 100871
China
8610-62768188 (Phone)
8610-62768266 (Fax)

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