Momentum, Market States and Downside Risk

Abstract

This thesis investigates momentum trading strategies during times of market turbulence. Momentum strategies have been shown to be profitable during multiple time periods in various equity markets and across different asset classes. However, one issue that momentum strategies face is the limited profitability during market downturns and the vulnerability to crashes. Another practical issue for momentum is the regulations on the short-side of its strategy during extreme economic conditions. As such, it is crucial to investigate and accurately interpret what drives momentum according to its vulnerability to crashes and regulations. In light of the frequent gains coupled with occasionally huge losses found to be typical of momentum strategies, it is also important to improve existing momentum strategies to better capture market trends. This thesis explores issues related to the vulnerability of momentum to crashes and regulations and ultimately endeavours to offer a solution. It consists of four essays addressing issues on the downside risk of momentum strategies across various market states. It empirically investigates these issues and contributes to the understanding of momentum risk management. Specifically, the first study analyses the vulnerability of momentum to financial crashes; the second study investigates the impact of short-selling restrictions on informed momentum trading; the third study introduces a new strategy that distinguishes between upside and downside risks in the calculation of trading positions; and the final study examines the asymmetric performance of decomposed momentum portfolios. The resultant empirical findings fulfil literature gaps and provide valuable insights into the management of momentum downside risk during times of deteriorating business conditions and market states.