The DMS system trades ETFs (although can be expanded to other securities). Currently it follows 45 ETFs, ranking each of them according to a proprietary momentum formula.

Bull and bear , symbolic beasts of market trend

Highest-ranked-momentum ETFs can be considered for long trades. Lowest-ranked ETFs should be avoided or considered for short trades.

This article presents the rationale for momentum trading and two systems.  It also provides ten-years of back-test results. With user-selection options, 24 different outcomes (backtests) are presented. The worst of these outperforms a buy and hold S&P 500 strategy by a factor of three. The best of these do so by more than 20 times.

What is Momentum Investing?

A general definition of momentum and how it pertains to investing is provided by AQR:

Momentum is the phenomenon that securities which have performed well relative to peers (winners) on average continue to outperform, and securities that have performed relatively poorly (losers) tend to continue to underperform.

Efficient Market Hypothesis (EMH) advocates claim there is no mechanical trading strategy that outperforms markets on a consistent basis. Research on market efficiency began almost sixty years ago as a joint project between Merrill Lynch and the University of Chicago. Eugene Fama, considered the strongest advocate of EMH, was awarded a Nobel Prize recently for his work in this area. (To learn more about efficient markets, try this article.)

The one anomaly that EMH believers have difficulty explaining is the positive bias of momentum trading:

“Momentum, in my view, is the biggest embarrassment for efficient markets,” Fama said, admitting that he was “hoping it goes away.” [Source]

[As an aside, I had Dr. Fama as a professor at the University of Chicago (and also played basketball with him in lunch-time pick-up games). He was the second-best professor I had, second only to Milton Friedman. He was objective, intellectually honest and provided clarity in class. He would not get a Nobel Prize for his basketball ability, nor would any of the rest of us who partook.]

How is Momentum Measured?

There is no single measurement of momentum. Many technical indicators purport to measure it. Some even include momentum in their name.

Oscillators (stochastics, MACD, RSI, etc.) measure momentum for an individual stock. However, these only tell whether that stock’s momentum is accelerating or decelerating versus its own recent performance. Momentum investing requires relative measurements to determine which assets have better momentum versus others.

Measures as simplistic as RSI values for stocks can work. The decision rule would be to buy (sell) the stock with the higher (lower) value.

Relative momentum measures need not be simple, but they are required.

A Simple Momentum-based System

Some approaches to momentum are simple but may still be effective. For example, a popular subscription-based website has a model that allows users to tailor parameters to create their own momentum-based systems. This approach consists of three variables — two measures of return and one measure of volatility. Users specify the time periods over which the measures are calculated. They then weight the importance of these variables.

The system is a black box but it appears that each stock or ETF is ranked by its rank-order for the defined measures. The weightings of these variables are then applied to these rankings to create a composite value. This composite is then re-ranked. The highest (lowest) ranked assets are then bought (sold).

The system is simple and polished. As a former subscriber, I recommend it for those who want to try momentum trading. The site used to allow limited free testing and perhaps still does.

Dynamic Momentum

A dynamic momentum system is dynamic in the sense that it adjusts with market conditions. While it may begin with fixed weights or relationships as explained in the simple momentum-based system, it has the capability to self-adjust. These adjustments can be complex, affecting elements according to class groupings or in various disproportionate ways. Alterations may not even go in the same direction for all assets.

Some general examples that could be built into dynamic systems are the following:

There examples show ways that dynamism or adaptivity can be added to straightforward momentum measurements.

The DMS System(s)

The DMS (Dynamic Momentum System) differs from other momentum approaches in that it allows variables and weights to self-modify in response to market conditions.

Three variables are user selected:

Three trading styles (Normal, Aggressive or Conservative) are available. These choices reflect the amount of risk that an investor wants to assume. The number of assets (in this case ETFs) to be traded is determined by the user. Finally, the user has the option to trade Long or to engage in both Long and Short trades. Users can alter any of these at any time.