Trend Following and Momentum Strategies › Trend Following and Momentum Strategies

In the previous chapter, we explored mean reversion strategies that profit when prices deviate from equilibrium and subsequently return to historical norms. Momentum strategies take the opposite philosophical stance: rather than betting against recent price movements, you bet that winning assets will continue winning and losing assets will continue losing. This seemingly simple idea, that "the trend is your friend," has generated consistent profits across asset classes and time periods, presenting one of the most persistent anomalies in finance.

Momentum is not a single strategy but a family of approaches that exploit the tendency of asset prices to exhibit persistence. The two primary variants are time-series momentum, which compares an asset's current price to its own historical prices, and cross-sectional momentum, which ranks assets relative to their peers. Time-series momentum forms the foundation of Commodity Trading Advisor (CTA) strategies that trade futures across global markets, while cross-sectional momentum underlies many equity long-short strategies. Both variants share common behavioral roots in investor psychology but differ substantially in implementation and risk characteristics.

The persistence of momentum returns poses a challenge to the efficient market hypothesis we discussed in Part IV. If markets efficiently incorporate all available information, why should past returns predict future returns? The answer likely involves a combination of behavioral biases such as investor underreaction to new information, structural frictions that prevent immediate arbitrage, and compensation for bearing crash risk. Understanding these sources helps you design momentum strategies and anticipate when they might fail.