Friday, April 24, 2015

Why FOMO Fails: Trending Markets Are Not Necessarily Momentum Ones

As I speak with traders, I notice a common mistake that is responsible for quite a few losses:  the confusion between trend trading and momentum trading.  They are not the same thing.  Traders who fear missing out on a trending move and chase strength or weakness frequently get whipsawed and stopped out.

Let's define our terms:

An asset that is trending is making higher highs (lower lows) and higher lows (lower highs) during a given lookback period.  If you imagine a regression line for price as a function of time, the line would be the trendline and there would be a noticeable positive or negative slope over that lookback period.

An asset that is trading with momentum tends to continue in the direction in which it has been trading.  Strength tends to be followed by strength; weakness by weakness.  Think of that regression line that is the best fit for a given trend.  If price oscillates widely around that line (i.e., the fit is not great), this is because the trending asset is not trading with momentum.  When price is strong, it tends to fade and vice versa.  A line that is a very good fit suggests momentum in the direction of the trend.

When traders assert that there is a trend and then buy strength (or sells weakness) to ride the trend, they are assuming that the trend also displays momentum.  That ain't necessarily so.  Buying strength in an uptrend and selling weakness in a downtrend is a great way to underperform in a trend market that is not a momentum one.

Let's go to the excellent Paststat site for a couple of illustrations.  A technical indicator is a useful and familiar measure of price strength and weakness.  If an asset shows momentum effects, it should demonstrate significant strength following high indicator readings and significant weakness following low readings.  Different indicators incorporate different lookback periods, so a look at several is useful if we want to gauge momentum over differing time periods.

To start, let's say we buy SPY when it closes above its upper Bollinger Band and hold for five trading days.  Over the past three years, this has resulted in 40 trades.  Of those, 24 have been winners and 16 losers for an average gain of +.04% and a profit factor of 1.13.  Meh.  No distinctive upside edge to buying strength, but also no significant weakness.  This fits with my research:  when price strength occurs with positive breadth thrust and elevated momentum, there is a greater probability of upside follow through than when the strength occurs with little oomph.  Averaged together, we see no meaningful tendencies.

Now let's buy SPY when it closes below its lower Bollinger Band and hold for five trading days.  Now we have 43 trades:  28 winners and 15 losers for an average gain of +.98% and a profit factor of 3.14.  That's a meaningful bullish tendency.  It suggests anti-momentum following weakness.  When price has dropped significantly, we've tended to bounce.

The trader who bought strength and sold weakness during the last three years lost money on average.  It has been a trending market, but not a momentum one.  Executing based on momentum has turned a normally winning trend strategy into a losing one.  Think about traders who trade with a "fear of missing out", and you can appreciate why that emotional pattern is so costly!

OK, so let's buy SPY when its RSI is above 70 and hold for 5 days.  Now we have 122 trades over a three year period:  60 wins, 62 losses, for an average gain of +.02% and a profit factor of 1.08.  Meh.  If we buy SPY when its RSI has been below 30, we have 24 trades:  18 up, 6 down for an average gain of +1.79% and a profit factor of 7.08%.

It's interesting that traders often emphasize trading with the trend but not chasing trades.  That's an implicit realization that a directional bias doesn't have to be a momentum bias.  Many trends are traded best when they look as though they're ending.

Further Reading:  Price Momentum and Cycles