Momentum and Reversal Dynamics

This paper studies the joint dynamics of momentum and reversal strategies in the U.S. stock market. Momentum investors face uncertainty about whether past patterns of price movements will continue (momentum) or reverse, thereby increasing volatilities of momentum returns and occasionally leading to momentum crashes. We find that the forces that drive reversal over momentum tend to be strong if losers’ past return is extremely low in the time series or if losers are small and illiquid in the cross section. Consequently, we propose new risk-managed momentum strategies that take into account the behavioral divergence between momentum and reversal. Empirical tests for the U.S. stock markets in the sample period of 1947 to 2015 document that momentum strategies in which investors implement stop-trading rules if losers’ past returns are extremely low as well as buy-small-loser rules substantially outperform traditional momentum strategies. Importantly, we find that the outperformance is mainly attributable to the increase in abnormal returns (or alpha) from various factor models.