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For years market researchers have known that momentum works. In a perfectly efficient market momentum should have been arbitraged away long ago, but the outperformance of the strategy has persisted for years, decades, even centuries. It is perhaps the single strongest evidence that markets are in no way fully efficient.
The simple explanation for the phenomenon is crowding behavior. Despite our large brains that can perform complex symbolic manipulation, we are nothing but glorified monkeys and the instinct for group behavior is so hardwired in our genes that we can’t help it, That’s why prices go to extremes and why momentum continues to work despite its seemingly excess returns. (See bitcoin).
However, making money from momentum is a lot harder than it looks. Momentum is, after all, just another word for trend and trend trading as we all know can be subject to horrid whipsaws that can drain away all the trend gains.
That’s why I was fascinated, the other day when I stumbled across an episode of Better System Trader podcast interview of Gary Antonacci who invented the idea of dual momentum.
Gary’s basic premise is that there two types of momentum – absolute and relative. Absolute momentum shows a rate of change against the instrument itself, so for example if the S&P 500 is rising relative to last month it is showing absolute momentum. Relative momentum shows the instrument’s performance against related instruments say – S&P 500 versus the DAX.
Gary’s thesis is that when both absolute and relative momentum is in place, the chance of outperformance vastly improves. There are numerous examples on his website with links to his book and there is even a better discussion of the concept on a blog that I found doing research for this column.
This is great reading both for intellectually curious and for those who invest for the long term, but how does it apply to us, traders? Ironically enough before I even came across Gary’s ideas, I stumbled upon the very same concept in my own trading. Playing Leibniz to Gary’s Newton I realized that dual momentum is crucial to my day trading trend setup as well.
As many of you know I have been refining my trend strategy for months and the EA is finally taking shape. It hasn’t reached the “Platonic” ideal, but it’s as close as it is going to get. Yet just as I was about to put the finishing touches on the code, I realized that I could improve my entries by adding an absolute momentum filter. If you assume that the basic trend breakout signal is evidence of relative momentum ( a currency pair is outperforming its peers) then filtering on time frames can help you a gauge the absolute momentum (i.e. a pair shows momentum on 1M vs. 5M or 1H vs. 4H and so on).
Since I trade on the short time frame, I now never take trades on the 1M chart if 5M chart does not confirm the trend. But the principle is universal. You can apply it to 1H vs. 4H charts or Daily vs. Weekly. The key concept is that both absolute and relative momentum must align.
As always this filter is more valuable for keeping you out of trades rather than taking them, but that’s precisely the point. The primary value of dual momentum is to keep you out of losing trades. That is its main advantage versus buy and hold investing and that’s why it helps with day trading as well. To paraphrase Ben Franklin on this July 4th – a stop avoided is a take profit earned.