12 – M4 L1B 13 Momentum Or Reversal V3

Factors can be broadly categorized as either momentum or reversal factors. We’ve previously referred to reversal as mean reversion. A momentum factor suggests that an existing trend will continue. A reversal factor suggests that a trend will change and go in the other direction. Say we have a hypothesis that the trend of stocks one year return will continue in the same direction. In other words, winners keep on winning and losers keep on losing. Let’s call it a one-year return momentum factor. When the one year return is higher for stock A compared to stock B, this indicates that we expect stock A to have a higher near-term return compared to stock B. Now, let’s look at a possible reversal factor. Say our hypothesis is that weekly stock returns are being reverting, that is, when a stock increases over a week, we expect that it will give up some of those gains due to profit taking. What I mean by profit taking is that other investors may sell after recent price gains in order to lock in their profits. So, the weekly return for stock A is higher than the weekly return for stock B, then we expect future returns on stock A to be lower compared to stock B. Similarly, if the weekly return of a stock is negative, our hypothesis assumes that the stock may be oversold. It might trend backup as other investors try to buy the stock at a cheaper price. So, to write these calculated returns as factors, the momentum factor is just the one year return, whereas the reversal factor is the negative of the weekly return. Remember, that a factor is some manipulation of raw data plus a hypothesis on what that data means in terms of the relative future performance of the assets.

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