Avoiding Momentum Crashes: Dynamic Momentum and Contrarian Trading
33 Pages Posted: 30 Mar 2017 Last revised: 18 May 2020
Date Written: March 15, 2017
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 in one month 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 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.
Keywords: momentum, downside risk, crash risk, trading strategy
JEL Classification: G12, G14, G15
Suggested Citation: Suggested Citation