Return Stacked® Academic Review

Explaining Momentum Strategies Using Intrinsic Price Fluctuations

2025-02-25

Authors

A. N. Baltas
SSRN Working Paper Series, December 2011
Explaining Momentum Strategies Using Intrinsic Price Fluctuations

Key Topics

return stacking, portfolio construction, risk management, capital efficiency, momentum, trend following, portable alpha

Decoding the Momentum Effect Through Price Decomposition

The momentum effect, where stocks that have performed well recently tend to continue performing well and vice versa, is a cornerstone of quantitative finance. In “Explaining Momentum Strategies Using Intrinsic Price Fluctuations,” A. N. Baltas delves into this phenomenon by decomposing stock prices into intrinsic modes. Utilizing Empirical Mode Decomposition (EMD), the study breaks down price movements into a long-term trend and a series of short-term oscillations. This approach provides a nuanced understanding of how different price components contribute to the success of momentum strategies.

Baltas analyzes data from NYSE, AMEX, and NASDAQ stocks over the period from 1962 to 2008. The study reveals that momentum profits are most pronounced in stocks exhibiting high short-term variability but low long-term variability. This suggests that momentum is influenced not just by persistent trends but also by the nature of price fluctuations across different time horizons. By identifying an optimal holding period of six months, the research balances return maximization with the minimization of transaction costs.

Impact of Transaction Costs and Risk Management

Figure 1: The Effect of Transaction Costs on the Sharpe Ratio (Original: Figure 5)

The bar diagram presents the effect of various levels of transaction costs to the annualized Sharpe ratio of selected momentum strategies. The strategies are: S1 — traditional single-sort momentum, S2 — double-sort on return and volatility, S3 — double-sort on trend and quarterly fluctuation metrics. All strategies have a 6-month lookback period, a 1-month skip period, and holding periods of 1, 3, 6, and 12 months. Transaction costs are assumed to be 0, 25, and 50 basis points on opening/closing positions.
Figure 1 illustrates how transaction costs impact the risk-adjusted returns of different momentum strategies. As costs increase from 0 to 50 basis points, the annualized Sharpe ratios decline across all strategies, particularly for shorter holding periods. This highlights the importance of considering trading expenses when implementing momentum strategies. Longer holding periods, such as six or twelve months, demonstrate greater resilience to transaction costs, underscoring the advantages of a longer investment horizon.

Figure 2: Dollar Growth for the Double-Sort Trend/Fluctuation Strategy with Stop-Loss Rules (Original: Figure 6)

The figures show the dollar growth of the double-sort momentum strategy S3 before and after applying stop-loss rules for holding periods of 6 and 24 months between 1990 and 2008. Stop-loss boundaries are 15%, 10%, and 5% for the 6-month horizon, and 20%, 15%, and 10% for the 24-month horizon. For comparison, the 6-month horizon includes the dollar growth of a strategy investing in the market-weighted index.
Figure 2 demonstrates the effectiveness of incorporating risk management techniques such as stop-loss rules. For a 6-month holding period, applying stop-loss thresholds smooths out the growth trajectory and reduces volatility. Over a 24-month horizon, strategies with stop-loss rules generally outperform those without, highlighting the benefits of active risk management in momentum investing. These findings emphasize the practical value of integrating risk controls to enhance portfolio stability and returns.

Integrating Momentum Insights into Return Stacking Strategies

Baltas’s insights have significant implications for return stacking strategies, which aim to enhance diversification and capital efficiency by combining multiple sources of return within a single portfolio. Understanding the interplay between trends and oscillations in price movements can inform the construction of diversified portfolios that harness alternative risk premia.

For instance, incorporating momentum strategies with optimal holding periods can be synergistic when combined with trend following approaches in a return stacking framework. By aligning the investment horizons and managing transaction costs, investors can achieve a more efficient portfolio. Similarly, the research on stop-loss rules aligns with the principles of portable alpha, where leveraging uncorrelated strategies can enhance returns without proportionally increasing risk.

The emphasis on risk management techniques, such as stop-loss thresholds, is particularly relevant when combining strategies like momentum with carry futures yield. Effective risk controls can mitigate drawdowns and contribute to more stable returns, which is a key objective in return stacking portfolios.

Key Takeaways

A. N. Baltas’s study offers a deeper understanding of the drivers behind momentum strategies by decomposing stock prices into intrinsic components. The research highlights that momentum profits are influenced by both long-term trends and short-term fluctuations. Key findings include:
  • Optimal Holding Period: A six-month holding period balances return maximization with transaction cost minimization.
  • Transaction Costs Impact: Higher transaction costs significantly reduce risk-adjusted returns, especially for shorter holding periods.
  • Risk Management Benefits: Applying stop-loss rules enhances performance and reduces volatility, emphasizing the importance of risk controls.
These insights are valuable for constructing return stacking strategies that aim for capital efficiency and diversification. By integrating momentum strategies with considerations for transaction costs and risk management, investors can potentially improve portfolio performance. The study underscores the importance of a nuanced approach to portfolio construction, where understanding the intrinsic components of price movements can lead to more effective investment strategies.