What is the Difference Between Trend Following and Momentum?

Trend Following vs Momentum

One of the questions I get a lot of the time, is that I use the term trend following and I use the term momentum, what’s the difference?

Essentially trend following and momentum are, in strategy style, at least, one and the same thing. It’s like a basket of fruit; it’s all fruit, you’ve got some oranges, some apples, some bananas. They’re all fruit, but each one is slightly different in texture and taste, etc. So that’s much the same as trend following verse momentum. They’re the same thing, but there are slight differences which we’ll now discuss.

What’s the difference between trend following & Momentum?

Both generate profits from what we call price persistence or trends. Markets and specifically individual stocks manifest themselves in trends and we do know that whilst trends don’t exist in all stocks, all of the time, they do exist in most stocks, some of the time. Simply put directional price trends, tend to persist long enough to exploit and profit from. And that’s what both trend following and momentum is all about. They both try to gain a positive expectancy by cutting losers very quickly and allowing the profitable trades to continue to run and continue to build on those profits. The focus for both is not necessarily on the accuracy of trades, I think that this is where a lot of amateur traders get it wrong, they’re looking for accuracy, trend following or momentum really doesn’t focus on accuracy in any way, shape or form.

Win/Loss

Rather it focuses on the win/loss ratio or in other words, how much you win when you win minus how much you lose when you lose and that’s what we talk about with positive expectancy. Now, I mentioned that trend following and momentum are in strategy style, one and the same thing, but on a more granular basis, they’re slightly different.

This is a chart of mineral resources, this is an ASX stock, and it’s showing a pretty clear uptrend that’s been persistent for 10 months. Yes, there’s some periods where it sort of goes sideways for a little while and dips a little bit, but more or less, we have a very nice strong uptrend in place.

Now, when we look at a stock or a currency or an index on its own, and we make a trading decision based solely on that instrument, then that called trend following. The technical term we could use his absolute momentum, but for the vast majority of people it’s called trend following. So let me reiterate that when we look at a stock on its own and we make a trading decision based solely on that instrument and its price movement, then that’s called trend following.

Growth Portfolio

Here’s another example, this is ARB Corp, and it’s a position I currently have in the Growth Portfolio. Now, many of you know, the Growth Portfolio that I’ve traded for the last 22 years or so is based loosely on the Bollinger Band Breakout that I introduced in “Unholy Grails” back in 2012.

It’s a trend following strategy because it’s only looking the Bollinger Bands and the trend of ARB on its own. So when ARB breaks the upper band you buy and when it breaks the trailing stop, you sell. Here’s another example, this is Dubber Corp. And again, another position I have in the Growth Portfolio, simply we’re looking at the Bollinger Band of Dubber and we will buy it when it breaks the upper one.

You can see there’s a buy there 205, anyone that knows anything about Bollinger Bands, you can see that sideways consolidation from around sort of November, 2020 through to April, 2021 bands would have contracted during that period of time and then we get the breakout and off we go. It’s just the Bollinger Bands of Dubber and the trailing stop when that breaks down through that red line, which is the trailing stop, we will exit the position.

Okay, so that’s trend following, or sometimes what I refer to is absolute momentum.

Relative Momentum

So what’s relative momentum? so relative momentum is when we compare the momentum of one symbol to that of another symbol or better still our universe of symbols, such as the ASX 100 or the NASDAQ 100, whatever it might be. On this chart, we’ve got our mineral resources and we’ve overlaid AMP. You can clearly see the differences AMP is going down, mineral resources is going up so the relative momentum favors mineral resources. If we were to rank these to i.e compare one to the other mineral resources would sit atop of AMP because the trend or the momentum is up, whereas AMP is down.

Top 20 Stocks in the ASX

Here’s a list of the top 20 stocks in the ASX 100 measured by their momentum as at a week or so ago. Now what we do here to calculate momentum, we calculate the price momentum and there’s several ways you can do that, you use rate of change, you can use linear regression there’s plenty of ways you can do it. What we want to do is measure the price momentum of all those symbols over a certain period of time and then we compile those readings from the highest momentum all the way down to the lowest ones.

You can see here Afterpay is at the top there, Resmed is second, and we’ve got IDP Education is third, so on and so forth. If we were to trade a relative momentum strategy, what we would be doing is buying, we would be listing these stocks like this, ranking them, and then we would be buying a top five or 10 for no other reason that then they’re exhibiting higher momentum than all the other stocks. Then we’d repeat that process every week or every month or every quarter for some. So, as the momentum in one stock starts to wane, it gets replaced by another stock that’s exhibiting higher levels of momentum, and that’s what we call relative momentum.

Theory Evidence

Here’s some evidence behind that theory, now this is our ASX momentum strategy, which we offer inside The Chartist and is one of the strategies that I personally trade. What we’re doing in this particular strategy we’re trading the ASX 100, we’re using a fixed allocation of five positions, and we are measuring the momentum over a set period of time. This strategy shows us a compounded annual growth rate from year 2000. The last 20 odd years of 22%, and it’s got a maximum drawdown of 25%. That is very favorable compared to a buy and hold where you would have a drawdown of 50, 52%. You’ve got an annualized return of around 9%. So that gives you a bit of an idea.

Underwater Equity Curve

Obviously, the other important benefit of getting out of positions when markets turn bearish, so this is what we call an underwater equity curve. The orange line is the momentum strategy, you can see there that has regular dips and equity of around 10 to 15%, but it does not and did not have the big sell off like we saw back in 2008, or like we saw back in the COVID crash March last year.

So March last year, this strategy went to cash on the 1st of March and remained that way until the 1st of June where momentum turned back up. It plays a very good defensive position as well. Here is the defensive position that we’re talking about you can see here when the portfolio goes to cash, it’s only invested 70% of the time and you can see it misses those big drawdowns when they come along, such as what we saw in the GFC. So this strategy went to cash in March, 2008, and remained that way until June, 2009.

Momentum

Momentum look, it’s validated by very strong academic research that goes for decades and all sorts of market conditions. The good thing with trend following or momentum, it stays invested in the strongest markets or sectors or stocks, tends to reduce exposure and sustain bear markets and out of favor sectors. You can actually see as the strategy rotates between the sectors so you don’t have to predict what sectors going to be the next best thing you’ll automatically be put into that sector as it starts to bubble to the top.

Systematic Approach

The way I do it, it’s completely systematic, non-emotional I don’t even look at charts to simply push the button the computer does the calculations and everything else for me. The portfolio dynamically adjusts and rebalances over time and literally I’ve said workload here half a day a month, but I’m trying to be quite conservative I’d suggest 10 to 15 minutes that’s probably it. Some difficult things with it, for people buying strength, very difficult, selling weakness. It’s kind of, very unnatural to do that. People like to buy a bargain, buy something that’s going down in the hope it goes up, but you never know when it’s going to stop going down, look at AMP, it keeps going down. It can underperform some more active strategies at turning points ’cause it’s a little bit slower to get out.

We’re not trying to pick the top or the bottom, which is waiting for it to turn. Can be commissioned sensitive, ours aren’t commissioned sensitive ’cause they really don’t do a great deal of trading. So, you know, really good for self managed, super funds that tax office doesn’t like to be seen to be doing a lot of trading.

ASX

Our ASX strategy as an example does about 12, 13 trades a year. We also run these kinds of strategies on the US as well. The average hold period tends to be about three times the rebalanced period. So what that is saying is that you’re not gonna be holding too many positions for more than 12 months. So there’s going to be some tax considerations in there, but even so, the benefits of this kind of a strategy far outweigh the benefits or non-benefits of holding for 12 months.

Trade these Strategies

If you’re interested in following some of these kinds of strategies that I trade. I trade all of these ones personally. So you will be getting the exact same positions, the exact same performance as I do. The ASX Momentum that’s inside thechartist.com.au, we’ve got the US Momentum Strategy, which trades Russell 1000 stocks, that’s also inside The Chartist. Lastly, we’ve got my aggressive NASDAQ strategy, the Premium Portfolio, which is over on our sister site tradelongterm.com. There’s some food for thought for the weekend, if you’ve got any questions, just hit email, I’ll return email, and I’ll be happy to answer those for you. So have a good one, good trading and we’ll speak next week.