Even experienced traders can be confused by similarities and differences between trend-following trading systems and momentum trading. Trend following is completely technical, while momentum systems rely heavily on price-volume analysis, while sometimes having fundamental components.
A big study in the early 1990s confirmed “persistence” was widespread. University of California, Los Angeles professors Jegadeesh and Titman published ‘Returns to buying winners and selling losers: Implications for stock market efficiency’. They found US stocks which had outperformed over the past three to 12 months usually continued to outperform.
Researchers extended investigations across regions and timeframes and discovered persistent outperformance was true across many markets. Also, stock indices which were outperforming their own long-term returns tended to continue outperforming.
Persistence is the basis of both trend-following and momentum systems. (Both styles predate this study). Trend followers identify trends (up or down) and take positions in the direction of trend. All signals are based on price-volume. Trend followers prefer commodity futures or stock futures where either direction may be traded with equal ease.
Trends often fail. When a trend is profitable, it must be milked for the maximum return. So, effective trend-following systems use trailing stop-losses and maintain a position for so long as the trend is alive. Trend-following systems usually avoid being time-limited for the above reason. Many trend-following traders also avoid trading stocks (as opposed to trading in stock futures, or index futures) because of lack of leverage and long-bias.
A momentum trader identifies an asset is “relatively stronger” than the market, or stronger than its peers or outperforming its own historical returns. Relative strength could be purely technical, as in the study cited above. Or there could be some fundamental factor (such as relatively quick earning growth) or a combination of fundamental and technical factors involved.
Most momentum systems are long-biased. This is sensible in equity-focussed trading because shorting stocks is much more difficult than buying stocks. Momentum positions may be non-leveraged if delivery is taken for equity. Quite often, momentum trades are short-term, since it is popular for day traders.
Successful traders often use additional filters. Some trend followers will also not take trades “against the market”. In a widespread bull market, a trend follower will not trade any short trend. Vice-versa, he will not be long in a wide bear market. This risks low diversification-the entire portfolio may be long or short if such filters are applied.
There are times when both types of systems select the same assets. There are also times when momentum systems and trend-following select totally different assets and times when they offer opposed signals on the same asset. A trending asset may not show up as a good momentum trade when it is not “relatively stronger”. Vice versa, a high relative strength asset may not have a trending priceline.
The details of such systems vary. Some systems are simple, with single triggers. Other trading systems have multiple signals and filters. Timeframes also vary. Failure rates are always high, regardless of the complexity or lack of complexity. There are two essential elements in common to successful trading systems. One is that a good system picks up the big moves. Two, a good system will minimise losses when the trade goes wrong.
Right now, most long-term trend-following systems are signalling long Nifty. Short-term to intermediate term trend-following systems are neutral or long. Momentum systems with intermediate or long-term time frames are also long-Nifty. The consensus obviously suggests staying long. The trick is to set appropriate stop-losses to get the trader out, if persistence breaks down.
The author is a equity and technical analyst
