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Lesson 09 · Momentum

Time-Series Momentum: A Simple Trend Following Strategy

  • 12 short cards
  • About 5 min to read
  • 5 quiz levels · 30 questions
  • Beginner

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Overview

Time-series momentum is a simple, slow trend following strategy. Once a month you ask one question about each market: is it higher than it was 12 months ago? If yes, hold it. If no, step aside into cash, or, in some funds, sell it short.

Timeframe
Checked once a month
Markets
Index ETFs, bonds, commodities, currencies, futures
Difficulty
Beginner

Builds on: Moving Average Crossover Strategy, Position Sizing and the 1% Rule in Trading

See it on a chart

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  • Price (candles)
  • 10-period SMA
  • Long signal
  • Short / exit signal

A monthly chart. Each candle is one month. Price closing above or below its 10-month average switches the position on and off. Prices are made up for illustration.

What is momentum?

In trading, momentum means the tendency of a price that has been rising to keep rising for a while, and a price that has been falling to keep falling.

Time-series momentum looks at each market on its own. It compares today’s price with the price a set time ago, called the lookback, often 12 months. If the market is higher, you hold it. If it is lower, you don’t.

The whole strategy, once a month

  1. Month-endTake each market in turn
  2. One questionIs it higher than 12 months ago?
  3. YesHold it
  4. NoMove to cash or short-term bonds

What the research found

A 2012 study by Moskowitz, Ooi and Pedersen tested this on 58 futures and similar contracts covering share indices, currencies, commodities and government bonds, over more than 25 years. A market’s past 12-month return helped predict its return for about the next year, before the effect partly reversed over longer periods1.

A later study by Hurst, Ooi and Pedersen found trend following was consistently profitable in data going back to 18802. Past results like these don’t guarantee future ones.

The 2012 study at a glance

Markets tested58 futures and similar contracts
Types of marketShare indices, currencies, commodities, government bonds
Time coveredMore than 25 years
FindingA market’s last 12 months helped predict about the next year, then the effect partly reversed

A simple version: the 10-month moving average rule

Mebane Faber popularised an easy version3: at the end of each month, compare price with its 10-month simple moving average. If price is above it, hold. If it is below, move to cash.

Only check on the set date, called the rebalance date. Ignore what happens in between.

Worked example: the 10-month average rule

End of May: the last 10 monthly closes add up to £980
Average £98
Price closes at £101: above the average
Hold
End of June: the average is now £99
Price closes at £96: below the average
Move to cash

You only look on the set date at the end of each month. What happens in between doesn’t count.

The risks

Trends can reverse suddenly. Research by Daniel and Moskowitz found that momentum strategies in shares can suffer sudden, very large losses, called momentum crashes, often when markets rebound sharply after a big fall4. Trend following can be hurt in a similar way at turning points.

Because you only act on monthly signals, you will be late at tops and bottoms. A whole year can be flat or negative. Funds spread risk by trading many different markets.

They also use volatility targeting: giving each market a size that makes its expected swings similar. Here volatility is usually measured as a yearly percentage. If you want each holding to swing about 10% a year and a market typically swings 25%, you put 10 ÷ 25 = 40% of your money into it.

Volatility targeting: aiming for a 10% yearly swing in each market

MarketTypical yearly swingShare of the money it gets
Shares25%10 ÷ 25 = 40%
Commodities20%10 ÷ 20 = 50%
Gold15%10 ÷ 15 = 66.7%

Livelier markets get less money and calmer ones get more, so each one moves your account by a similar amount. Each row is worked out on its own.

Time-series momentum rules

Entry

  • At the end of each month: if the 12-month return is positive (or price is above its 10-month average), hold the market.

Exit

  • At the end of each month: if the 12-month return is negative, move to cash or short-term bonds.

Risk

  • Size each market so they swing by similar amounts.
  • Spread your money across different types of market.
  • Only act on the set monthly date.

Worked example: two monthly checks

  1. End of March: an index ETF is at 100. Twelve months earlier it was 92, so it is up 8.7%. You hold.
  2. End of September: it is at 95. Twelve months earlier it was 103, so it is down 7.8%. You sell and move into short-term bonds.
  3. You check again at every month-end, and buy back when the 12-month return turns positive.

Pros and cons of time-series momentum

Strengths

  • Very simple and quick to run.
  • Historically helped limit losses in long falling markets.
  • Few trades, so low costs.

Weaknesses

  • Late at turning points.
  • Can be whipsawed in choppy years.
  • Long flat periods test your patience.

Key terms

Momentum
The tendency of rising prices to keep rising, and falling prices to keep falling, for a while.
Lookback
The period used to measure past returns, such as 12 months.
Rebalance
The set date when you check signals and adjust positions.
Volatility targeting
Sizing each market so its expected swings are similar.
Momentum crash
A sudden, very large loss when trends reverse sharply.

Sources

Numbers in the lesson, like 1, point to these sources.

  1. Moskowitz, Ooi and Pedersen (2012), “Time Series Momentum”, Journal of Financial Economics. AQR summary page.
  2. Hurst, Ooi and Pedersen (2017), “A Century of Evidence on Trend-Following Investing”, Journal of Portfolio Management. AQR.
  3. Faber, M. (2007), “A Quantitative Approach to Tactical Asset Allocation”, Journal of Wealth Management 9(4). Journal article (no link).
  4. Daniel and Moskowitz (2016), “Momentum Crashes”, Journal of Financial Economics (NBER working paper 20439). NBER.

Lesson complete

You have reached the end of the lesson. Now test what you learned with the five-level quiz.

Start the quiz

Quiz zone

Test yourself: Time-Series Momentum quiz

Five levels, from the basics to expert judgment. Clear each level to unlock the next.

  1. Level 1: Foundations. Recognise the strategy and its vocabulary.
  2. Level 2: Mechanics. Know how the signals and rules work, and why.
  3. Level 3: Application. Apply the rules to realistic chart situations.
  4. Level 4: Numbers & risk. Size, measure and manage the trade with real calculations.
  5. Level 5: Mastery. Judge edge cases, failure modes and market conditions.

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The questions only. Answers and explanations appear when you take the quiz above.

Level 1: Know the basics

  1. Time-series momentum decides whether to hold a market based on…

    • the company’s profits
    • whether RSI is below 30
    • whether it’s higher or lower than it was a set time ago
    • what the news says

  2. What is a common lookback period?

    • 12 days
    • 12 months
    • 12 minutes
    • 12 years

  3. True or false: in the version that never sells short, a negative 12-month return means moving to cash or bonds.

    True or false?

  4. How often does a typical version check its signals?

    • Once a year
    • Whenever the news changes
    • Once a month
    • Every minute

Level 2: Understand the idea

  1. What does momentum mean in trading?

    • Prices never change direction
    • Busy markets move faster
    • Rising prices tend to keep rising for a while, and falling prices keep falling
    • Prices always bounce back

  2. In the 2012 study, how long did the 12-month signal tend to help predict returns?

    • About one day
    • About a year, before partly reversing
    • It didn’t help at all
    • Forever

  3. True or false: checking every day instead of once a month usually means more trades and more costs.

    True or false?

  4. In Faber’s simple version, what does price closing above its 10-month moving average mean?

    • Buy double
    • Sell everything
    • Sell short
    • Stay invested

  5. How far back did the Hurst, Ooi and Pedersen study look?

    • To 2010
    • Just the last 5 years
    • To the year 1000
    • To 1880

Level 3: Use the monthly rules

  1. At month-end the index is at 4,200. Twelve months ago it was 4,500. What does someone who never sells short do?

    • Sell short
    • Move to cash or bonds
    • Hold and wait
    • Buy more

  2. In the middle of the month, the index jumps 6%, but its 12-month return is still negative. The rules only check at month-end. What do you do?

    • Change your rules
    • Sell short
    • Wait for the month-end check
    • Buy straight away

  3. Your 12-month returns are: gold +15%, bonds −4%, shares +6%. Which do you hold, if you never sell short?

    • All three
    • None
    • Gold and shares. Bonds go to cash
    • Only gold

  4. After a 35% fall, shares bounce 20% in two months, but the 12-month return is still negative, so the system stays in cash. What does this show?

    • You should always ignore the rules
    • Momentum never works
    • Being late at turning points, a known cost of trend following
    • The system is broken

  5. Using Faber’s rule, price closes the month below its 10-month average. What do you do?

    • Buy more
    • Move to cash
    • Hold
    • Wait a year

  6. What is the rebalance date?

    • The day the broker pays interest
    • The day prices are lowest
    • The set date when you check signals and adjust positions
    • Any day you feel like checking

Level 4: Work out returns and sizes

  1. A share index is at 120. Twelve months ago it was 100. What is the 12-month return, in percent?

    Type a number (%).

  2. The price is now 100. Twelve months ago it was 92. What is the 12-month return, in percent? Give one decimal place.

    Type a number (%).

  3. The price is now 95. Twelve months ago it was 103. What is the 12-month return, in percent? Type a minus sign for a fall. Give one decimal place.

    Type a number (%).

  4. The last 10 monthly closes add up to 980. What is the 10-month average?

    Type a number ((the average)).

  5. You want each holding to swing about 10% a year. A market typically swings 25% a year. What share of your money should it get, in percent?

    Type a number (%).

  6. Same 10% target. Commodities typically swing 20% a year. What share of your money should they get, in percent?

    Type a number (%).

  7. Same 10% target. Gold typically swings 15% a year. What share of your money should it get, in percent? Give one decimal place.

    Type a number (%).

Level 5: Understand its role

  1. What is a momentum crash?

    • When a broker goes bust
    • When prices stop moving
    • A slow, steady loss
    • A sudden, very large loss when trends reverse sharply, often during a fast rebound

  2. Why do trend following funds trade dozens of markets rather than one?

    • Because one market is never enough to trade
    • To make sure every month is profitable
    • To pay more fees
    • Trends in different markets don’t all happen at once, so spreading out smooths results

  3. You test lookbacks from 1 to 24 months and pick 7 months as the best. What’s a more reliable approach?

    • Use a blend of several lookbacks, such as 3, 6 and 12 months
    • Change it every month
    • Test until you find a perfect one
    • Use exactly 7 months forever

  4. A system was flat for 18 months while shares rose, then made 25% during a crisis. Which describes its role?

    • A day trading strategy
    • A broken system
    • A diversifier: it often does well in long, strong moves, including big falls, but lags in calm rising markets
    • A way to beat shares every year

  5. Why does volatility targeting give calm markets more money and lively markets less?

    • To trade fewer markets
    • Because calm markets always make more profit
    • So each market moves your account by a similar amount
    • To avoid all losses

  6. Your trend system has a flat, slightly negative year. What should you remember?

    • Double your size next year
    • The strategy is finished
    • Switch to whatever did best this year
    • A whole year can be flat or negative. That’s a known part of trend following

  7. Why will a monthly trend system always be late at tops and bottoms?

    • Because data arrives late
    • It waits for the 12-month return or the average to turn, which happens after price has already turned
    • Because it’s badly designed
    • It isn’t late

  8. The research found trend following worked back to 1880. What does that tell you about next year?

    • It will make exactly the average
    • It will definitely make money
    • Nothing certain: past results don’t guarantee future ones
    • It will definitely lose money

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