I have been trying to quantify my momentum trading strategy. Mean reversion pays the bills, but I am still an “IBD style” trader at heart. That may sound crazy to you, given the subjectivity, and that’s why I am doing the study. I was able to contrive testable criteria for market timing and stock selection. The real challenge is in conducting the tests. If you have better resources than I do, please use this as a blueprint.
For market timing, you can use O’Neil’s method or Wilder’s ADX. For my study, I used the 90% up volume method. This shows an uptrend beginning, conveniently, on Jan.1, 2013.
For stock selection, I used the modified Levy ratio described previously. Levy’s research showed that there is a momentum effect. Mine didn’t, at least not with a buy and hold strategy. I selected all the stocks in my database that met my liquidity requirements and had 131 days of history as of Jan 1. Here, already, I am at odds with O’Neil, who would be favoring the young, the small, and the sparsely traded. I did test the IBD 50. We’ll come to that later.
I divided my selection into quintiles based on their Levy ratio as of Jan 1. The total returns after six months are shown below, with an average of 15.2%. The extra 5% for the momentum group looks good, but the bottom quintile also outperformed! So, I computed differential returns for one, three, and six month periods, along with standard deviations and z-scores. None were statistically significant.
Undeterred, I loaded this group into a breakout strategy and backtested it for January through March. My idea is that momentum, if it exists, is good for maybe three months. Regularly updating the watch list will ensure I am always trading high flying (or peaking) stocks. By the way, my breakout strategy is a simple one based on Bollinger band compression and a parabolic trailing stop. A typical good trade looks like this:
The momo group performs well over the three months. It only wins 46% of trades, but the winners are 4.8 times as large as the losers. This is what you would expect for this trading style. It has a tight stop, fails fast, and lets winners run. It’s the opposite of mean reversion, where you expect better odds.
I tested the other four groups, and they were terrible. I had been thinking, well, it’s a bull market and anything will fly. I tried different groups, different timeframes, and different stops. Finally, I dragged out an old IBD 50 from Dec. 15, 2012. It also performed poorly. None of them did as well, with this strategy, as the momo group.
Of course, the fickle thing about momentum trading is timing the market. Today, we are in a “confirmed uptrend,” and I am still uncomfortable buying breakouts at new highs. If you want to do it, that signal is: six days of BB compression and an entry stop at the Keltner line. Good luck!