Technical Indicators

Momentum Trading

Q: What is the best window for measuring it?

The most tested is twelve months excluding the most recent one, known as 12-1. Six- and nine-month windows also work reasonably. Excluding the last month matters because a short-term reversal effect contaminates the signal. Shorter three-month windows tend to generate more signals, more transaction costs and more false positives without improving quality.

Q: Is momentum useful for trading 45-day options?

It is useful as a directional filter, not as an entry-signal generator. Momentum operates on a scale of months while a 45-day options trade operates on weeks, so the trend gives you the bias — which side of the market to favour — but not the timing. A common and sensible use is restricting put selling to names with positive momentum and call selling to names with negative momentum, letting IV Rank decide whether selling premium makes sense at all.

ES: Trading de Momentum PT: Trading de Momentum

Trading in the direction of what is already moving: why it is one of the best-documented anomalies, how it is measured, and why its risk arrives all at once.

The best-documented anomaly

Momentum is the tendency of assets that have performed well in the recent past to keep doing so, and of those that have performed poorly to keep falling. It is one of the most empirically supported anomalies in finance: it has been documented in equities, bonds, currencies and commodities, across many countries and over periods spanning more than a century. The classic window is three to twelve months of past return as a predictor of the following months. Its persistence is awkward for the efficient markets hypothesis, and precisely for that reason it has survived enormous academic scrutiny.

Why it exists

There are two families of explanation and both probably contribute. The behavioural account holds that investors underreact to new information — price adjusts slowly to good news — and then overreact once the trend is obvious, drawn in by the move itself. Added to this are documented biases: anchoring on purchase price, aversion to realising losses, and herding. The risk-based account holds that momentum simply compensates a real risk: that of suffering a sharp, correlated crash when the trend exhausts. The second explanation has the virtue of predicting exactly the way momentum fails.

How it is measured

Three main approaches. Cross-sectional momentum ranks a universe of assets by return over the chosen window and buys the best while selling the worst; this is what quantitative funds use and what dominates the academic literature. Time-series momentum looks at each asset against its own history: buy if its twelve-month return is positive, sell if negative, with no comparison to anyone else. And technical indicators — moving average crossovers, ADX, MACD, 52-week highs — are simpler proxies for the same idea. One important technical detail: the academic convention excludes the most recent month, because at very short horizons a reversal effect dominates and contaminates the signal.

The characteristic risk: the momentum crash

Momentum has a return distribution with negative skew: it produces steady positive returns over long stretches and then suffers abrupt, severe crashes. These episodes occur characteristically at violent turns following a decline, when the most beaten-down names — which the strategy is short or simply avoids — rebound harder than anything else. March 2009 and November 2020 are the standard case studies: momentum portfolios suffered enormous losses within weeks precisely as the broad market recovered. The operational lesson is that this strategy’s risk does not manifest gradually but concentrated into a few days, which makes it particularly hard to manage with stops.

Momentum with options

Options allow expressing a momentum thesis with profiles the underlying does not offer. The most direct application is the directional debit spread: capped cost, defined risk and leverage on trend continuation; it suits low IV Rank, because you are buying premium. A widely used alternative is selling puts or bull put spreads with the trend, which profits if the asset rises, stands still or even falls slightly, and additionally benefits from the elevated volatility that usually accompanies strong moves. In-the-money LEAPS allow holding exposure to a multi-month trend with less capital. What almost never works is buying far out-of-the-money calls after a vertical rally: that is when implied volatility is most expensive and reversal risk is highest.

Frequently Asked Questions

Does momentum not contradict mean reversion?

Only in appearance, because they operate over different horizons. At very short horizons — days — reversion dominates. At medium horizons — three to twelve months — momentum dominates. At very long horizons — three to five years — reversion reappears, which is the foundation of value investing. They are not contradictory principles but phenomena governing different time scales, and specifying the horizon is what removes the confusion.

What is the best window for measuring it?

The most tested is twelve months excluding the most recent one, known as 12-1. Six- and nine-month windows also work reasonably. Excluding the last month matters because a short-term reversal effect contaminates the signal. Shorter three-month windows tend to generate more signals, more transaction costs and more false positives without improving quality.

Is momentum useful for trading 45-day options?

It is useful as a directional filter, not as an entry-signal generator. Momentum operates on a scale of months while a 45-day options trade operates on weeks, so the trend gives you the bias — which side of the market to favour — but not the timing. A common and sensible use is restricting put selling to names with positive momentum and call selling to names with negative momentum, letting IV Rank decide whether selling premium makes sense at all.

How do I avoid buying right at the top?

You cannot avoid it entirely, and anyone claiming otherwise is describing the past. What you can do is limit the damage with three measures: staggering entry across several tranches rather than all at once, using defined-risk structures so the worst case is known, and avoiding buying premium when IV Rank is high, which is exactly the state after a vertical rally and what turns a timing error into a double loss.

Does momentum work in indices or only in individual stocks?

It works in both, but differently. In individual stocks the cross-sectional effect is stronger, because there is wide dispersion between winners and losers. In indices, time-series momentum — comparing the index against itself — is more applicable and is the basis of trend-following strategies. The advantage of trading it in indices is avoiding single-company idiosyncratic risk; the disadvantage is that the signal is weaker.