12 – M4 L3b 12 Skewness And Momentum Momentum Enhances Or Weakened By Skew V2

Let’s walk through four hypothetical examples and assume that skewness is a reversal factor, which is another word for mean reversion. We’ll be more specific and say that the maximum daily return over the trailing month is our measure of skew. Let’s also assume that the return over the trailing year is a momentum vector. Notice that it’s more precise to call our definition of skew as a measure of positive skew. We aren’t defining negative skew with a minimum over the trailing month. Even though this is also a valid approach, for simplicity, we’ll just be measuring positive skew. Remember, the Alpha vector is a relative ranking exercise. In our first scenario, let’s say momentum is positive and skew is positive. This is the scenario that we saw in the introduction to this factor. We can think of the positive skew as having a dampening effect on the positive momentum of the stock. The paper calls this weakened momentum. For our second scenario, let’s say momentum is still positive, but the skew is less positive. The less positive skew may indicate that future returns maybe stronger than if there were a positive skew. The paper calls this enhanced momentum. For our third scenario, we’ll look at negative momentum and positive skew. The paper describes this scenario by suggesting a phenomenon where investors are overly optimistic about a downward trending stock when the stock bounces backup temporarily. The hypothesis continues to suggest that when the stock rebounds positively, individual investors may see this as a sign of recovery so they may buy as well. To conclude this scenario, as fundamental still put downward pressure on the stock, the momentum then reasserts itself and the stock continues to slide downward. This scenario is also referred to as enhanced momentum and is the primary scenario for which the researchers found more significant effect of skewness on momentum. For our fourth scenario, we’ll look at negative momentum and less positive skew. The less positive skew has a dampening effect on the negative momentum, so it can be referred to as weakened momentum. Now that you’ve seen how momentum and skew interact, can you think of how these can be combined into a conditional factor?