Killing the Momentum
Monday, September 9, 2013 at 9:02AMThe challenge in mean reversion strategies like pairs trading is to find opportunities with value that are about to mean revert. Often, relationships with significant statistical value have strong momentum in one direction. This is true in pairs trading, value investing, and many other relative value trading strategies.
The key in trading these relationships is finding the catalyst for a momentum change. In most market conditions, it is a futile exercise to trade pairs on the basis of statistical value only. One must also understand the dynamics that are in place to kill the momentum that has pushed the relationship into the area of statistical value.
Don't enter into a statistical trade unless you have strong conviction that a catalyst is evolving to kill the momentum. That is how we think about this at Bigger Capital.
What are your thoughts on this topic?
Written by Michael Bigger. Follow me on Twitter and StockTwits.
Reader Comments (6)
I find that you can often use a technical catalyst just as effectively as a fundamental catalyst. For instance, if a spread between two shares has continued to climb for several weeks and reached an historically level, you could use a break below a moving average that has supported most of the up trend.
Perhaps the technical signal is merely a clue to the coming fundamental change as the 'insiders' are making adjustments before the general public is aware of what's going on. This has worked well for me in the futures markets.
Thank you Jason for this interesting comment. We use TA for that specific reason in our spread Analyzer. We also use the spike alert. A spike is often indicative of a reversal..
Spot on, Michael. I often look for catalysts like dividend payment, shift in investors sentiments (large to small cap and vice versa, defensive v.s. cyclical etc.). What kind of catalysts do you often look at ?
I used our spike alert. I define a spike a 2 sd move over a one half life period. I also look at big news changing the dynamics.
So... The CATALYST evolving to kill the MOMENTUM, [if we are talking under the Technical Analysis Sight] IS IT A MARKET INEFFICIENCY? ... and if so, why? Could a Fat-Spike in the right CONTEXT kill the Momentum for a little while and then Revive it back?... so everybody might "JUMP" in the wrong [Pool] direction? Hero or Villain?
Francaselles, I think so.....and yes, it could come back in the wrong pool. Just the risk of trading.