Modeling Momentum and Reversals

Abstract

Stock prices are well known to exhibit behaviors that are difficult to model mathematically. Individual stocks are observed to exhibit short term price reversals and long term momentum, while their industries only exhibit momentum.

Here we show that individual stocks can be modeled by simple mean reverting processes in such a way that these behaviors are captured, and that market efficiency is preserved (in the sense of Jarrow and Larsson, 2011). Simulation shows that in such a market, when mean reversion is sufficiently high, strategies which use reversals would substantially out-perform long-only strategies.

Keywords: portfolio optimization,trading strategy, mean reversion, reversals, momentum

JEL Classification: G11, C5