White Paper Combining Momentum and Mean Reversion in a Short-term Trading Model

introduction

Are stock prices predictable? Proponents of the efﬁcient market hypothesis (EMH) believe they are not. According to the theory , prices always reﬂect all available fundamental information. Since future news cannot be predicted, asset price changes are impossible to forecast as well. However various market anomalies have been observed by academics and have challenged EMH. Obvious examples are asset price bubbles and crashes, which seriously question EMH, French (1988). It seems widely accepted that markets are at least not fully, but mostly efﬁcient. Two inefficiencies are momentum and mean reversion. Both are the foundation of the quantitative T echnical Swing trading model, which is available on covestor.com and are also applied by various hedge funds, who focus on statistical arbitrage strategies.

I will first introduce both i nefficiencies and then discuss practical aspects of the trading approach.

momentum

Momentum in terms of securities trading refers to the technical expression: once a body is put in motion, it keeps moving as long as no new forces are applied. The same can happen to securities under certain conditions. The Economist (2011) described the momentum effect in a recent issue: "Since the 1980s academic studies have repeatedly shown that, on average, shares that have performed well in the past continue to do so for some time. The effect is one of the strongest market anomalies known by analysts." Jegadeesh (1993) was one of the first, who documented its persistence and found abnormal returns of momentum-based strategies while looking at data from 1965 until 1989. In fact, even recent literature reports significant outperformance when assets showed relative strength in the prior 3 to 12 months.

Fig 1:

Whole Foods Markets, Inc. (NASDAQ: WFM): a typical momentum stock, which has outperformed the S&P 500 since 2009.

It seems still controversial why the momentum phenomenon exists. The research field of Behavioral Finance is trying to explain momentum as well as the mean reversion anomaly by analyzing psychological factors of the crowd. However, the underlying reasons are irrelevant from a practitioner's point of view. Page 2

Momentum

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