What Is Absolute Price Momentum?
Absolute price momentum is an investment strategy within quantitative finance that focuses on the rate of change in an asset's price over a specific period, holding that assets that have performed well recently will continue to perform well in the short to medium term. This approach identifies securities that are exhibiting strong upward price trends (winners) or strong downward price trends (losers) without comparing them to other assets or a benchmark. It is a core component of momentum investing, which falls under the broader category of factor investing and often involves systematic trading.
History and Origin
The concept of momentum in financial markets has anecdotal roots dating back centuries, with traders like David Ricardo and Jesse Livermore observing that "cut short your losses" and "let your profits run on" suggested an attention to trends28. However, the modern academic understanding and empirical validation of absolute price momentum largely emerged from seminal research in the early 1990s. Notably, Narasimhan Jegadeesh and Sheridan Titman's 1993 paper, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," provided significant empirical evidence for the profitability of momentum strategies25, 26, 27. Their work documented that strategies buying past "winner" stocks and selling past "loser" stocks generated significant positive returns over 3- to 12-month holding periods, challenging prevailing assumptions about market efficiency at the time24. This research helped lay the groundwork for momentum to be recognized as a distinct investment factor.
Key Takeaways
- Absolute price momentum identifies securities based on their individual past price performance, not relative to other assets.
- The strategy typically involves buying assets with recent strong positive returns and selling or avoiding those with recent strong negative returns.
- It operates on the premise that past price trends tend to persist for a certain period.
- Absolute price momentum is a key component of quantitative investment strategies and factor investing.
- While historically profitable, the strategy is subject to periods of significant drawdowns, often referred to as "momentum crashes."
Formula and Calculation
The calculation of absolute price momentum is straightforward, typically involving the percentage change in an asset's price over a look-back period.
A common way to calculate absolute price momentum (often for a single asset) is:
Where:
- (P_t) = Current price of the asset
- (P_{t-n}) = Price of the asset (n) periods ago (the price at the beginning of the look-back period)
- (n) = The number of periods in the look-back window (e.g., 3 months, 6 months, 12 months)
This formula yields the rate of return over the specified look-back period, indicating the strength and direction of the price trend. The look-back period is a crucial parameter, with common choices ranging from 3 to 12 months in financial models.
Interpreting Absolute Price Momentum
Interpreting absolute price momentum involves evaluating the magnitude and direction of the calculated price change. A positive and sufficiently large momentum value suggests a strong upward trend, indicating that the asset has been performing well and might continue to do so. Conversely, a negative and significant momentum value points to a strong downward trend, suggesting the asset is underperforming.
Investors and portfolio managers often use thresholds or rankings to interpret these values. For instance, an asset might be considered a "winner" if its absolute price momentum over the past six months is above a certain percentage, or if it falls into the top decile of a broad market's momentum scores. The interpretation is often combined with other analytical tools and a broader investment thesis. Understanding the holding period for which momentum is expected to persist is also critical for effective application.
Hypothetical Example
Consider a hypothetical stock, "Tech Innovations Inc. (TII)," which closed at $100 six months ago. Today, TII's closing price is $115.
To calculate the 6-month absolute price momentum for TII:
In this example, TII has an absolute price momentum of +15% over the past six months. This positive value indicates that the stock has experienced an upward price trend during this period. An investor using an absolute price momentum strategy might interpret this as a signal to consider buying or holding TII, assuming the trend is likely to continue for some time. This approach contrasts with relative strength strategies, which would compare TII's performance to other stocks or a market index. The investment strategy would then define how this momentum signal translates into actual trades, such as setting a stop-loss order to manage potential reversals.
Practical Applications
Absolute price momentum finds practical applications across various facets of investing and market analysis, particularly within quantitative and systematic strategies. One primary application is in factor investing, where momentum is recognized as a persistent factor contributing to excess returns23. Asset management firms, particularly those focusing on quantitative strategies, often incorporate absolute price momentum signals into their asset allocation models to identify securities or asset classes with favorable trends.
For instance, a global macro strategy might use absolute price momentum to identify strong trends in global equities, currencies, or government bonds, positioning itself long assets with improving fundamental macroeconomic trends and short those with deteriorating trends20, 21, 22. This can include analyzing trends in business cycles, international trade, monetary policy, and risk sentiment19. Moreover, it can be used in the construction of momentum exchange-traded funds (ETFs) and mutual funds that systematically invest in securities exhibiting strong past performance. It also plays a role in risk management, as understanding price trends can inform decisions about when to reduce exposure to assets showing negative momentum or to increase exposure to those with strong positive trends.
Limitations and Criticisms
While absolute price momentum has demonstrated historical efficacy, it is not without limitations and criticisms. A significant drawback is its susceptibility to "momentum crashes," which are infrequent but severe periods of underperformance, particularly during market rebounds or reversals17, 18. For example, a strategy that buys past winners and sells past losers could experience substantial losses when losing stocks rebound sharply, as seen in 2009 after the global financial crisis16.
Another criticism revolves around the debate over whether momentum profits are truly "anomalies" reflecting market inefficiency or simply compensation for risk14, 15. Behavioral finance theories suggest that momentum arises from investor underreaction to new information, followed by a delayed overreaction12, 13. However, the profitability can also be sensitive to factors like trading costs and liquidity, potentially eroding theoretical gains in real-world implementation11. Furthermore, the performance of absolute price momentum can vary across different market regimes and can be impacted by changes in market volatility10. Researchers continue to explore methods to mitigate these crashes and enhance the robustness of momentum strategies, such as by incorporating signals like the high-yield spread to predict potential reversals9.
Absolute Price Momentum vs. Relative Strength
While both absolute price momentum and relative strength are key concepts within technical analysis and momentum investing, they differ in their comparative approach. Absolute price momentum focuses solely on an individual asset's past performance in isolation. It measures how much a specific stock, bond, or commodity has gained or lost over a defined period, independent of how other assets have performed. The goal is to identify assets with strong, self-contained trends.
In contrast, relative strength compares the performance of one asset against another asset, a group of assets, or a market index. For example, a relative strength analysis might compare the performance of a technology stock against the S&P 500, or against other stocks within the technology sector. The aim is to identify assets that are outperforming their peers or the broader market. While absolute price momentum signals when an asset is trending, relative strength indicates whether that trend is stronger or weaker than other available options, influencing portfolio construction decisions.
FAQs
What is the typical look-back period for calculating absolute price momentum?
Common look-back periods for calculating absolute price momentum range from 3 to 12 months, with 6-month and 12-month periods being frequently used in academic research and practical applications. The choice of look-back period can significantly impact the strategy's performance and is a key parameter in quantitative models.
Can absolute price momentum be applied to asset classes other than stocks?
Yes, absolute price momentum can be applied to various asset classes, including commodities, currencies, and fixed income. The principle of price persistence is observed across different markets, and strategies often use momentum signals to allocate capital across a diverse range of investments for diversification benefits6, 7, 8.
Is absolute price momentum a short-term or long-term strategy?
Absolute price momentum is typically considered a short-to-medium-term strategy, with holding periods ranging from 3 to 12 months. While some studies have explored longer-term momentum effects, the most robust evidence generally points to persistence over these shorter horizons. Beyond a certain point, momentum can reverse, leading to mean reversion5.
How does absolute price momentum differ from value investing?
Absolute price momentum and value investing are fundamentally different investment approaches. Absolute price momentum focuses on recent price trends, buying assets that have gone up and selling those that have gone down, regardless of their underlying valuation. Value investing, conversely, seeks to identify assets that are trading below their intrinsic value, often characterized by low price-to-earnings or price-to-book ratios. These two strategies are sometimes seen as complementary or even antithetical in factor models.
What are "momentum crashes"?
"Momentum crashes" are rare but significant periods where momentum strategies experience severe and sudden losses. These often occur when past losing assets sharply reverse their trends and outperform past winners, leading to substantial drawdowns for momentum-oriented portfolios4. They are a known risk associated with momentum strategies and a subject of ongoing research in financial economics1, 2, 3.