Defining Momentum

 Having spent time in the market, you’ve probably heard a wide range of market jargon. We usually become familiar with these terms and even start using them without being aware of what they signify. I’m guilty of this too, and I’m guessing some of you can relate to that.

 Momentum is a term often used in discussions about the markets. It can be tricky to get a definite idea of what it is and how it’s calculated.

When asked, traders generally refer to momentum as the rate at which markets shift. While that is accurate to a degree, we should not restrict our comprehension of it to just that.

Momentum is a physics term that denotes the amount of motion possessed by an object. This same principle can be applied to stocks markets by substituting ‘object’ with stocks or the index.

In short, momentum can be defined as the velocity of stock or index returns. If these returns increase quickly, then the momentum is deemed strong; if they accumulate more slowly, the momentum is considered weak.

What is the rate of change of returns? This is the next logical inquiry.

The rate of change of return is a comparison of the yield (profited or lost) between two points in time. We’ll keep our focus on an end-of-day perspective, meaning the rate of change in returns signifies the speed at which a stock’s daily performance alters.

Think of this as an example to help illustrate the concept further.

The table exhibits the end-of-day stock value for a particular stock throughout the week. Pay attention to two things –

Prices are consistently increasing day by day.

The percentage alteration is at least 0.5% daily.

Here’s another example-

It is essential to be aware of two points.

Prices are increasing on a daily basis

The daily rate of change is 1.5% or greater.

Considering the actions of these two stocks, I have two queries for you –

Which stock has greater volatility in its daily returns?

Which stock has greater momentum?

To address the posed queries, you can take into consideration either the exact shift in Rupee value or the ratio change between one closing price to another.

By looking at the absolute change in Rupees, Stock A’s change appears greater than that of Stock B. However, this is not an accurate metric to measure daily returns. For example, stocks that are priced around 2000 or 3000 will always show a higher absolute Rupee change compared to Stock A.

Hence, relying solely upon an absolute Rupee change won’t be enough and so analysing the percentage shift is necessary. When it comes to its daily fluctuation, Stock B’s clearly bigger and thus we can deduce that its momentum is far higher than the other.

Here’s another situation to consider: 

Stock A has had a steady rise while stock B has been more of a mixed bag, yet when the overall change over the last seven days is taken into account, both have delivered comparable returns. Which one of these stocks should be seen as having the best momentum going forward?

Stock A is a definite contender, with daily returns that remain consistent, displaying a positive trend — one of continual momentum.

What if I alter the method of measuring momentum? What if we examine returns on a 7 day period instead of each day? Both Stock A and B would then fit the criteria for being considered as momentum stocks.

The point I’m endeavouring to make is that traders usually assess momentum by examining daily returns, a logical approach, yet it’s not the only manner of doing so. We will touch upon a momentum strategy in this chapter that examines momentum over a longer period rather than on a day-to-day basis. We’ll delve deeper into this later.

I hope you now comprehend momentum, which can be gauged not only through daily returns but also across longer time scales. High-frequency traders even measure it minutely or every hour.

– Momentum Strategy

One of the most used tactics employed by traders is the momentum strategy. There are various forms of measuring momentum to locate opportunities, but the basic concept remains constant – recognizing and exploiting a rise in momentum.

Momentum strategies can be developed for one stock or a universe of stocks. These strategies involve gauging the momentum of each stock and trading the ones with the highest amount of it. The strategy might revolve around either long or short trades, so traders following this path will find opportunities in both directions.

Traders also create momentum tactics geared towards a single sector and construct area-specific investments. The thinking is to discover the sector which shows powerful momentum. This can be done by monitoring energy in industry-focused indices. Once that region is pinpointed, further investigate the equities within it displaying the strongest momentum.

Momentum can be applied to portfolios too. I find this a great approach as it not only provides you with a momentum strategy, but also adds an extra level of safety through its diversified nature, featuring ‘n’ number of stocks.

In this strategy the concept is to construct a portfolio of 10 momentum stocks, which is maintained until the momentum endures. Afterward it should be readjusted.

– Momentum Portfolio

Prior to delving into this strategy, here are some things to consider: 

The point of this is to showcase how creating a momentum portfolio can be accomplished. Nonetheless, it is by no means the only approach to constructing such a portfolio.

If you don’t have programming skills, like me, then it’s best to find a friend who can help in implementing this strategy or creating any other momentum strategy.

Like any other strategy, this too has to be backtested

By utilising this information, a ‘Momentum Portfolio’ can be constructed through the following steps.

Step 1 – Define your stock universe

You are familiar with the nearly 4000 listed stocks on BSE and close to 1800 on NSE. These include the most valuable entities like TCS, as well as the Z category stocks at the other end of the scale that have had disappointing performances. So, do you need to keep tabs on all these securities to form a successful portfolio?

It wouldn’t be worth the effort. 

We need to form a ‘tracking universe’ by filtering out stocks. This tracking universe will include a vast selection of stocks which we will cherry pick to build our momentum portfolio – this portfolio will always only be a fraction of the tracking universe.

Imagine the tracking universe to be like your selection of preferred stores. Instead of needing to visit all of the hundreds of malls in your city, you could stick to a few which become your go-to locations. The clothes and items you purchase from these regular haunts become your entire wardrobe or collection. Therefore, these pick outlets from your tracking universe out of all the options in town.

The tracking universe can be either the Nifty 50 or BSE 500 stocks. A momentum portfolio will always be a subset of these – making the latter a good starting point, although one may choose to customise their universe if they’re feeling brave.

Custom creation can be manipulated according to any given parameter; for instance, from the 1800 stocks listed on NSE, a filter could be used to sift through the multitude and determine which ones have a market cap of at least 1000 Cr. This alone will reduce the list to much more manageable proportions. Additionally, I could add further criteria such as stock prices under 2000, and so forth.

I’m just throwing out a few ideas, but what it boils down to is that custom-created filters let you build a tracking universe perfectly suited to your needs.

To construct a momentum portfolio of 12-15 stocks, my personal advice is that you maintain a tracking universe of at least 150-200 titles.

Step 2 – Set up the data

Now that your tracking universe has been established, you can move to the subsequent step. Here, it is imperative for you to obtain the closing prices for all stocks in your tracking universe. It is important to guarantee that your dataset is both precise and adjusted for corporate events such as bonus shares, stock divisions, special dividends and other company decisions. An accurate dataset serves as a crucial element when it comes to any form of trading technique. Thankfully there are numerous data sources where one can fetch the data without spending a dime. Well-known sites such as NSE/BSE offer such services with ease.

What lookback period is needed for this strategy? Just one year, from 1st March 2018 to 2nd March 2019. For instance, as of today being 2nd March 2019, data points between these two dates are necessary.

When you have the figures from the past twelve months, it is possible to update this daily, which entails registering the end-of-day values.

Step 3 – Calculate returns

This is an essential part of the plan; here, we evaluate the returns of all the stocks on the list. As you likely figured out, we analyze the returns to acquire an understanding of the force behind each stock.

We discussed earlier in this chapter how one can measure the returns over any given time frequency. To continue our discussion, we will stick to yearly returns; nevertheless, you are free to adjust the strategy as you choose, by calculating half-yearly, monthly or even fortnightly returns.

Now, your tracking universe should include approximately 150-200 stocks that have historical data spanning one year or more. To proceed, you will need to compute the yearly return for each of these stocks.

To help you comprehend this better, I’ve created a sample tracking universe with around 10 stocks in it.

The data for the past 12 months is included in the tracking universe and the 1-year returns have been computed as well.

If you’re curious as to how returns are calculated, it’s quite uncomplicated. Let’s take the case of ABB for example.

Return = [ending value/starting value]-1

= [1244.55/1435.55]-1

= -13.31%

It appears to be simple.

Step 4 – Rank the returns

Once the returns are calculated, they should be ordered from greatest to least. For instance, Asian paints can boast a return of 25.87%, making them the front-runner in this lot. Therefore, their rank is 1. HDFC Bank follows with the 2nd highest figure and Infosys holds the lowest return of -35.98%, resulting in them having the last rank of 10.

Here is the ‘return ranking’ for this portfolio –

If you’re asking yourself why the yields on most stocks have been in negative territory, that is what typically happens when a bear market strikes. I regret not going over this strategy at an earlier time.

So, what is the ranking telling us? 

By considering the rankings, we can view our tracking universe from a different perspective. For example, Asian Paints is our highest yielder within the group over the last 12 months and Infy our lowest.

Step 5 – Create the portfolio

A typical tracking universe contains around 150-200 stocks, and with the assistance of our step by step process we have rearranged them. With this rearrangement, we can now move forward and create a momentum portfolio.

Momentum is the speed of return change, which is evaluated annually.

A momentum portfolio typically holds 10-12 stocks, which I’m comfortable with increasing to 15. For the purpose of this conversation, we’ll use 12 stocks as our foundation.

The momentum portfolio is now a selection of the top 12 stocks in the sorted tracking universe. Specifically, it would include the 1st to 12th ranked shares. To illustrate, if a 5 stock momentum portfolio was assembled, it would be composed of –

Asian Paints

HDFC Bank

Biocon

ACC

Ultratech

The rest of the stocks will not be part of the portfolio, but they will stay in the monitoring universe.

You may wonder why this subset of stocks was chosen from the universe used for tracking.

If the stock has yielded desirable returns throughout the last 12 months, it can be assumed that this trend will continue for another month. As such, investing in such stocks would likely provide you with lucrative outcomes.

This is an assertion I have made, of which I have no statistical evidence. However, I have applied it myself for a considerable time and achieved favourable outcomes. It can be easily verified via back-testing; please consider carrying out this analysis.

My trading partner and I were prompted to create this momentum portfolio after coming across an article in ‘The Economist’. It is essential to read it before attempting to put the strategy into action.

Once the momentum portfolio stocks are identified, the approach is to purchase them in equal parts. For example, if there are 12 stocks with a total capital of Rs.200,000/- available then each stock should be bought for Rs.16,666/- (200,000/12).

Constructing an equally weighted momentum portfolio is easy to do, although it can be tweaked to result in a skewed portfolio if there are viable reasons for doing so. Results should be backtested before any changes are made.

If you are looking to try something different with your portfolio, here are some potential options to consider.

Allocate 50% of capital to the top 5 momentum stocks (ranked 1-5), and the other half among the remaining 7.

The top 3 stocks earned 40% and the other 9 accounted for the remaining 60%.

If you are of a contrarian mindset, anticipating superior performance from lower ranked stocks, then allocate more funds to the bottom five.

Ideally, your approach to capital allocation should arise from a backtesting process. To find the most fitting technique, one should go through various approaches and put them to the test.

Step 6 – Rebalance the portfolio

So far, we have developed a tracking universe, determined the 12-month returns, ordered the stocks in terms of those returns and established a momentum portfolio by selecting the top 12 stocks. The momentum portfolio was formed on the basis of the past 12 months’ performance with an expectation that it will maintain its results for the 13th month.

There are a few suppositions to consider here-

The portfolio is created and bought on the 1st trading day of the month

This suggests that all the calculations take place on the last day of the month after the market has closed.

Once the portfolio has been put together and purchased, you retain the stocks until the month’s end.

What comes to pass at the termination of the month?

At the end of each month, the ranking engine is run again and the top 10 or 12 stocks which have done well in the last year are determined. To be taken into account, only the most recent 12 months’ worth of data is considered.

We should now buy stocks from rank one to twelve just like before. Chances are only a few stocks have changed positions in the initial portfolio. So, based on the list, you need to sell the stocks which are no longer part of it and purchase new ones which appear in the latest momentum portfolio. In short, rebalance your portfolio at month’s end.

So on and so forth.

– Momentum Portfolio variations

Before we finish, I’d like to go over a few slight variations of this technique.

The rate of return for a twelve month portfolio has been estimated and the stocks need to be held for only one month. But, you can experiment with your choices; such as:

Determine the return of stocks and assess them according to their monthly performance, and maintain the portfolio for that month.

Take the returns of stocks into consideration and rank them according to their fortnightly performance. Hold the portfolio for a period of 15 days.

Rank every week and keep it for seven days.

Calculate on a daily basis and even do an intraday momentum portfolio

The range of possibilities is extensive, only limited by your creativity. Recall that the momentum portfolio we discussed is based on prices, but you could also construct one with a fundamental approach. Here are some thoughts to consider –

Build a tracking universe of fundamentally good stocks

Note the difference in quarterly sales number (% wise)

Rank the stocks based on quarterly sales. The company with the greatest increase in sales should be number one, with the second highest getting rank two and so forth.

Invest in the 10-20 stocks with the most potential

Rebalance your portfolio at the end of every quarter to stay on track.

Any fundamental parameter can be tracked and tested, from EPS growth to profit margin and EBITDA margin. The advantage of such strategies is that the relevant data is readily accessible, making backtesting simpler.

 – Word of caution

The price based momentum strategy can be advantageous when the markets are rising; however, it does not hold up well during choppy or falling markets. The portfolio tends to suffer more than the markets themselves in such a scenario.

Having experienced the effects of this strategy’s behaviour with regards to market cycles firsthand, I can safely say that comprehending it is essential for the portfolio’s future prosperity. I lucked out in ’09 and ’10 but got burned in 2011 – a lesson that still stands today. Therefore, any individuals looking to employ this approach should be sure to do their studies beforehand.

Let me reassure you that a price based momentum strategy – when used properly within the market cycle – stands to provide satisfactory returns that can often exceed market averages.