REVERSING MOMENTUM: THE OPTIMAL DYNAMIC MOMENTUM STRATEGY

Abstract

We study the optimal dynamic trading strategy between a riskless asset and a risky asset with momentum (momentum asset). The most salient characteristic of momentum is that positive price shocks predict positive future returns. This characteristic leads to big swings in returns over multiple periods. Investors with relative risk aversion greater than one dislike such big swings. We show that it is optimal for such investors to reverse momentum by holding less or even shorting the momentum asset. We find that the optimal portfolio weight also depends on the historical price path, in addition to momentum. Different historical price paths, even if they have the same momentum, lead to different optimal portfolio weights. In particular, with rebound path (a historical price path that decreases at the beginning and then rebounds later to have a positive momentum), it is optimal for investors to hold less or may short the momentum asset and hence suffer less or even benefit from momentum crashes.