Equity Investing with Relative Momentum

Equity Investing with Relative Momentum

Published August 13th, 2021

Equity Investing with Relative Momentum

Let’s talk about relative momentum and specifically with equity investing. Normally relative momentum is associated with a portfolio of ETFs. However, as you will see in this article, over the last few years, or number reviews, we have been using it inequities. Before we go there, however, I just want to talk about my key investment goals, pretty straightforward, I’m not looking to hit it out of the park, or I’m not looking for the silver bullet or the holy grail. My investment goals are straightforward. First, I want to use proven strategies that are governed by evidence and facts, and not by opinion or discretion. I want to outperform buy and hold and mutual funds. Yet, I also want a strong element of capital preservation and it must be economical and time-effective. You will see with this portfolio, it literally only takes about 30 minutes per month.

You need to accept readily that this is a game of inches, and not of home runs and that progress is more important than perfection. So, as you can see there, some pretty simple kind of goals. But I’m also a firm believer that there’s always ways to improve. Improvement either in performance or risk management, or even the day to day processes, I’m always interested in what works for other people, and what they have to say, how they go about doing their daily business. Over the years, I have picked up snippets of ideas, and I’ve clinically tested a lot of them, and I’ve used what was beneficial, and I’ve discarded what wasn’t. I have got a graveyard of ideas and strategies sitting on my computer here, and it’s from these that I’ve managed to build a sweep of strategies that help achieve my various goals.

Now, back in 2010, whilst I was doing research for one of my books, I came across an investor who used monthly timeframes, for his decision making. Now, since I started trading back in 1985, I had always based my decisions on daily data, and whilst I’d thought about weekly data, it certainly never occurred to me to extend it out to monthly. Now, this investor, his results were outstanding. What I learnt from him became the basis, of some of the momentum strategies I trade today, and the aggressive one which we are going to talk about today in this discussion.

What is momentum? Momentum is basically, stocks that have done well in the recent past, tend to continue to do well, in the following months and even the following years. This is known as price persistence and not only can it be found in stocks, it can be found in commodities, foreign exchange, indices, and almost all markets, and unlike in the concept to that of a hitchhiker.

Now, if you’re going to hitch a ride from say, Sydney to Melbourne, you’re going to stand on the southbound lane of the highway, chances are standing in the northbound lane, won’t yield a ride to Melbourne. It’s probably going to yield a ride to Brisbane, rather than to Melbourne. In other words, we want to stand ahead of the movement, or we want to buy the strength, we do not want to buy into the weakness. My research shows a distinct edge from buying strength, rather than buying weakness.

Now, this is a chart I used in my 2012 book on holy grails. Basically what it shows is the probability of a loss, after holding a position for a certain period of time. That period of time is anywhere between 20 days and 300 days. Now the red line at the top of the chart here, it shows that the probability of loss, after holding a position buying a 52 week low, is relatively stable around that 52, 53% for any period out to 300 days. In other words, if you buy a stock at a 52 week low, then there’s a 54, 53% chance that, anywhere out to 300 days that position is still going to be a losing position. However, if you buy a stock, that’s making a 52 week high, you can see that over time the probabilities of a loss decrease. In fact, they get down to about 38% after holding for 300 days. So there’s a very slight edge, and that’s all we really need in this kind of environment, to make good money with this strategy.

There’s a similar study that shows buying the top third of the strongest stocks, and shows performance persistence, verse buying the bottom third of the stocks. And I’ll cite some other papers at the end of this presentation, that will provide further evidence of strength, prevailing over weakness.

I’m also a big believer in asking the question:  

Why does my strategy make money?

Now, the answer is not something simple or technical. It’s not because the stock bounces off the 200 day moving average, it’s not that it’s a Bollinger Band Squeeze, or it’s not trading below intrinsic value. They are not the reasons why your strategy makes money. They are simply tools, using a 200 day moving average, it’s a tool! It’s not the reason why. If you’re unable to answer that question, why does my strategy make money? Then the chances are, when you suffer a drawdown, or an extended flight period in your equity growth, which will happen, you’re going to be less likely to stick with your strategy, and you’re going to be more likely to actually drop it, and move on to a different strategy.

I call that the beginner’s cycle. Very, very common. The more you can understand why your strategy makes money, the more likely you are going to stay with it, through thick and thin.

Why does momentum make money?

Or simply put markets and specifically individual stocks, they manifest themselves in trends, and whilst trends don’t exist in all stocks all of the time, they do exist in most stocks, some of the time. Those trends can persist long enough, to exploit and therefore profit from. If we allow a trend to develop and we ride those trends, yet, remove positions that don’t develop into trends, in those losers, we allow a positive mathematical expectancy to be created, and that’s why you create profitability.

This positive expectancy is a similar profit profile to that of a basic call option, which I’m showing you right here. It’s the old, let the winners run, cut the losers, simple as that. Using the analogy of a hitchhiker, it’s very simple. Again, we are standing in the Southbound lane of the highway in Sydney, a car or a vehicle will stop for us. At that point, we don’t know how far that ride will take us. It may take us to the Southern suburbs of Sydney, it may take us to Wollongong, it may take us to Canberra, or it may take us all the way to Melbourne. We simply don’t know how far that ride will go. What we do know and what we can control, is if the ride turns around and starts heading in the wrong direction, we can hop off, and that’s the big difference there. We have the control to get off the ride if it’s not doing what we want it to do. But if it is doing what we want it to do, we just hang on and stay for the long term.

One of the major benefits of this concept, is that we avoid toxic stocks. We’ve all heard of these toxic stocks. Recently Valiant for example in the US, one of the big hedge funds was involved there, and they lost billions of dollars, because they fell in love with the story and the stock, and it kept going down and down and down. We’ve all heard of these examples and we’ve all been involved in these kinds of things.

Here’s a good example that I like to use in Australia and, this is an old one, but it just goes to show that this kind of stuff has always been around, and always will be around, but it’s how we avoid it. Now this is a classic example of an analyst, falling in love with a stock or even the story. Now this is the largest insurance company at the time in Australia. This was HIH, and this is the exact commentary from the insurance research analyst at a very large re brokerage firm. This was the largest corporate failure in Australia at the time.

You can see at the top here, we’ve got, “…we rate HIH as very undervalued… we retain a buy recommendation…” And that’s when the stock was trading at around $1.20. A few weeks later, stock filled at 80 cents. You can hear him say, “Our valuation remains reasonably solid at $1.65.” Nothing like a little bit of confidence, reasonably solid. Stock continues to plunge, and it’s gone down about 50%, a few weeks later, their analysis is now hold, and it continues to go down. Our valuation is now 80 cents, we maintain our hold, and then a month or so later, the stock goes bankrupt. The interesting thing, the day after this stock went bankrupt, the day after, this same analyst came out and just said, “research has been terminated” and that was it. No further information, nothing. It was just done and dusted, and that was it. That’s the last we ever heard of it. So, we don’t want to hold onto those kinds of positions.

To give you an idea of the mathematical expectancy of a strategy such as this, this is some personal stats of mine from the last three years of my Superfund account, or my retirement account is very simple and basic, metrics that simulate or simulate a trend following strategy, you can see up here, the win rate is around 51%. A lot of people say, “Well, that’s not particularly good.” Well, that actually doesn’t matter.. If you can take your focus off this win rate, then that leaves you to focus on the more important win-loss ratio here. What this is basically saying this mathematical expectancy, is out of every two trades I make, one’s going to be a loser, one’s going to be a winner. But, the winning trade is 3.35 times the loss of the losing trade. So for every dollar I lose, I make $3.35. So that creates a significant positive expectancy. Now what you can see here, is in this three year period, I’ve got a return of 83.3% that’s net, versus the market return of 28.56.  I’ve outperformed the market by almost three, two and a half, three times in that period of time, even though my win rate is just 50%. And that’s what I’m talking about in terms of having a positive expectancy, and momentum makes it a very, very easy way to achieve that.

The other benefit here, is during the 2008 crisis, this account actually suffered a drawdown of about 13%. So it’s not a painless exercise, but that’s significantly better than suffering a drawdown, of 35, 40 and for some funds up to 50%. That gives you obviously a bit more financial robustness, but psychologically makes you a lot stronger as well. The other thing to consider here is the concept of momentum is also timeless. It’s pervasive nature, and it’s deemed robust and reliable. Markets manifest themselves in trends and they always had. Markets can’t be trained. Anyone suggests to me the markets will stop trending, suggests that it’s possible to accurately price an asset. Or, that human behaviour, will change to a point where fear and greed completely disappear. We know that’s not the case, both are highly unlikely. So, we need to assume that trends will always remain.

Here’s a chart of US stock called Walgreens, and it shows two very separate periods of time. The first chart there at the top, 1956 through 1961, second chart, 2011 through to 2015, you can clearly see upward momentum at certain stages during these periods of time, it’s not all the time, but it’s enough to generate profits from.

Now that we get a brief understanding of the concept of momentum, and how it creates a positive expectancy, let’s discuss relative momentum. This is where we see a distinction between traditional trend following, specifically a trend following commodity funds, and also momentum. So, traditional trend following techniques, use single instrument specific metrics to identify the trend or the strength of the trend of the individual market. For example, buying stocks that make a 52 week high, we’re only looking at the individual stock in context of its own 52 week high, same could be said for entering positions on say a breach of a Bollinger Band or some other technical buyer point, we’re only looking at the individual symbol itself on its own merits.

Relative momentum, however, compares the strength of one stock or symbol, versus all the others in the traded universe. We’re only interested in those, that are exhibiting superior momentum, or price persistence, compared to all the others in the universe.

Here’s a visual example of what I’m talking about.

There are various ways to measure momentum by the way, this one is just using linear aggression, and I’ve got four different stocks here. The look back period for this linear regression is six months. What we’re actually looking at here, is the angle of their trajectory. The two upper companies, are two upper charts there, we’ve got Amazon and McCormick, and you can see those are exhibiting upward momentum. Nice upward pointing or linear aggression lines, clear trends in place. And then we’ve also the bottom two charts. We’ve got General Electric and Walmart. You can see that one is trending down, and the other is more or less flat. Interestingly enough, the large rise in Walmart on this chart, has not been enough to actually change that momentum at this stage. Now, obviously we can just look at the chart to gain some perspective on the momentum direction, but when we’re putting it towards a trading strategy itself, we need to be a little bit more precise. And what this chart shows, is the actual measurements of momentum of all the S&P 500 constituents. In this instance, we’re measuring momentum using rate of change, which is simply the percentage price change between two points of time, and in this case, we’re just measuring 90 days.

Now to the left of this chart, are companies exhibiting the strongest momentum, companies on the far right, are the exact opposite, they’re showing the weakest momentum and then it’s below zero. They’re obviously trending down, and these are the ones we need to avoid. In this particular week, we’ve got 315 companies exhibiting positive momentum, and they’re all different. Some are very, very strong, some are strong, some are going up, but not overly strong. When trading on a relative momentum basis, we’re only interested in the strongest of the strong, and this case, we’ve got AMD, Darden, El Lily, and Kroger for example. They’re the ones on the very, very far left, they’re the ones we want to buy. Now, some momentum strategies we’ll trade long and short, so they’ll buy those ones on the very far left, and they’re short solos ones on the very far right. It’s not something I do personally, nor do I have any research of my own to discuss it, and I stopped trading on the short side in late 2008, it was actually banned in Australia. I’m of the opinion now that, why have a strategy that when you need it the most, is not going to be available for you? That gives you a bit of an idea right there on the momentum of individual constituents, in a graphical format.

Pros & Cons of Momentum

Let’s have a look at the pros and cons here. On the positive side, momentum has been validated by extensive academic research, and over many decades in market conditions. It ensures you remain invested in the strongest stocks, or the strongest sectors, or the strongest markets.

For example:  Let’s just assume gold over the next five years, is going to go to $5,000. If we look back at that prior five years, where gold’s gone from 1200 to $5,000, and we ask ourselves, “What stocks did we want to own during this period of time?” Chances are you’re going to say, gold stocks. I want to be 100% invested in gold stocks. You don’t want to have bank stocks. You don’t want to have pharmaceutical stocks. You want to be in bank stocks because that’s where the big money was going to be made.

A momentum strategy is going to make sure, you stay in those stocks, that are showing the strongest trends. Importantly, it also reduces exposure to sustain bear market events, such as the GFC or the 2008 crisis. We will see shortly when used correctly, it’s an automatic process and will keep you into cash. It also keeps you out of those sectors that are not performing particularly well.

Minimal workload, I know it’s hard to believe that, you know really, less than an hour or two a month, don’t get me wrong, it took me 20 years to get to that point. But, it’s certainly possible, and it’s an ongoing habit of mine to continue to research. The actual execution of the strategy is very, very minimal on a month to month basis. However, I spend a lot of my time researching.

The complete removal of selection bias. Now selection bias is a common issue with standard trend style strategies, with a large universe of stocks. Basically, selection bias means you’re getting more signals than cash available. Then as a result, if you pick one stock over another, then you’re going to get a different outcome potentially to what someone else would get.

With momentum you don’t have that problem at all. Every single person, with the trading strategy will get the same stock and the same outcome. When we’re back testing, we know exactly what our return is going to be. However, on the against side, buying strength and selling weakness is unnatural, some people really struggle to do that. It can be a little bit commission sensitive, depending on the trade frequency settings.

This aggressive portfolio that we are talking about today, really does not do a lot of trades, about 15 trades a year. This month for example, we didn’t have to rotate any positions, so it continued to hold on. It’s very, very low frequency, but some of them can be a little bit higher frequency depending on your look back.

Tax considerations due to shortened holding periods, you know the average holding period generally is around 90 days. A lot of people will suggest that, you know, that’s too short because the tax. Well, I take the view of tax is like running a business and advertising. If you advertise your business, you’ve got to pay money for that advertising. If it reaps benefits well it’s worth doing, if it doesn’t reap benefits, well it’s not worth doing. It’s the same with shorter term trading and paying tax. If the benefits far outweigh, then do it. There are ways and means to lower tax rates legally. If you can find a strategy that gives you big risk adjusted returns, enables you to participate in the market and feel safe about it, that means not participating in the downside, and you’ve got to pay a little bit more tax well, so be it. You’re going to become better off in the longer term.

The other issue here is we don’t use any stops. Not at all. Now we do have an exit mechanism, don’t get me wrong. We will get out of stocks that are not performing, but you don’t have to get out of stocks using a stop loss. You can actually have an exit mechanism, which is what we have. Having no stops in the market can cause some anxiety, especially on large interim month declines. But let me give you an example where it actually can work for you, rather than against you.

If we go back to when Trump was elected in 2015, November 2015, I remember vividly, sitting here during Australian time zone, the S&P 500 futures in the night session, were down 100 handles. Limit down 100 handles, I was 100% long US equities going into that night, following a strategy as I should. Now, several people sent me emails saying, “Should we get out of our positions?” “Should we hedge ourselves with futures?” “What should we do?” my reply, “No, we’re going to follow the strategy.” As we know, the market turned around, and rallied all the way back up. In November 2015, my strategy actually finished up 10 and a half percent for the month.

Had we panicked on that emotional import of that election victory, then we would have actually finished with a bit of a loss for that month, rather than a solid month up. The other problem here is that we can have extended periods of holding cash and this can be difficult for people. The only people that it’s really not difficult for, those people who went through 2008 sitting in cash, following systematic approaches, and that’s exactly what we did. By the end of it, they understood the benefits of doing that. It’s a very simple thing to do, just go to cash, sit on the sidelines while everyone else is losing their head, and then you psychological you’ll be in a much better place to come back in, when the market trend resumed higher again. So, don’t be afraid to sit in cash, it’s not a bad thing. You don’t have to try it on the short side. You just sit in cash, get along with your life. Then when the market turns around, you’re back in again. So far we’ve looked at the general theory of momentum, but, let’s talk about it now in the real world and how we do it. I’m going to take you through a few simple steps on how we do it, and that should form a good foundation for you to research further.

Steps Involved

First of all, we need to choose some kind of method of momentum, and then rank it accordingly. There’s lots of ways to measure momentum. Rate of change is a very simple one, that is what I use for this particular strategy. Linear regression is another one, RAF regression, ADX. There’s all sorts of different ways you can do it. Don’t get too hung up on it. It’s all kind of doing the same thing.

Secondly, what we do, is we rank the strongest to the weakest. Here’s an example of a ranking watch list, that we use over at trade long term. You can see ranked number one, is advanced micro devices, AMD, and it’s got the highest rate of change. I still hold this stock, I’ve had this stock for a number of months, it’s been going very, very well. I have no idea how far it’s going to keep going, but what I do know, is if the momentum changes and starts to drop down, I’m going to hop out of this. What we want to be doing here is ranking, and you can see here that I’ve actually ranked to five decimal places, this rate of change. We put them all in there and we buy the top ones, that’s all we’re doing.

Next thing we do is we select a look back period, two points of time to measure momentum. I tend to find longer periods are better. 12 months tend to offer stronger results in my view, the way I do it, that’s generally agreed though, that a look back between anywhere between three and 12 months, is effective. Now we actually use two periods of time, both of which are actually weighted. And we do this more to differentiate our stock selections rather than attempt to optimize performance. I say that because a simple rate of change, anybody can calculate it. We don’t want to be competing with other people, so we just do things very slightly differently, and that just gives us very slightly different signals. We might enter, you know, a stock a different month rather than the other month or something like that.

Here’s a good example of look back stability. This also shows the robustness of momentum on its own. These top two charts represent a moving average crossover system in two different windows. We’ve got the first window 1992 to 2007. Now you can see here that, it’s a little bit bumpy and it kind of flattens out down through this area here. But, very, very bumpy. But if we go forward 2007 to 2015, you can see literally all the parameters, are negative. In other words, every single parameter is now unprofitable. Therefore, it’s not particularly robust, it’s worked very well in this period of time, but it hasn’t worked from 2007 through 2015.

However, if we now look at the lower chart, we’ve got momentum between 1992 and 2007, and you can see every single parameter is profitable, pretty flat across the here, which is a good sign. Then if we move forward between 2007 and 2015, same thing, every single parameter is profitable, pretty flat along here, and pretty flat along here, going down a little bit, but you can see that general area in this region here, around that 200 days in there is the most profitable period of time. That’s what I’m talking about, about our 12 month look back, tends to be the most profitable. Two completely different windows of time, and both looks very, very good.

That gives you an idea and the robustness of momentum versus something reasonably simple, like a moving average crossover system.

Step number three, is we need to calculate our position sizing. Now there are two broad ways to do this. Volatility adjusted position sizing, which is sometimes known as risk parody. There’s also fixed percentage allocation, which is where you allocate say 10% of your portfolio to each position. Now, there’s also two secondary considerations having a diversified portfolio where you have more positions, higher trade frequency, but less volatility and then you have a concentrated portfolio, where you have less positions, less trade frequency, but higher volatility. But it’s that high volatility that actually creates bigger return. Personally, I use a combination of methods, I use a volatility adjusted method on a broader universe, specifically the S&P 500, and that offers a lower volatility return profile and I also use a fixed percentage on a concentrated portfolio, specifically that’s the trade long term portfolio, which trades a Nasdaq 100. It provides a much higher return profile, but it also comes with much higher volatility.

To calculate a risk parody position sizing, beta, this is the formula, and beta is basically the impact of a position on the full portfolio value on any given day. A beta of 0.1 for example, will impact the portfolio by 10 basis points. A low beta will mean less capital allocated to each position and therefore more positions. Whereas a high beta means more capital is getting allocated to each individual position, and therefore total less positions will be held in the portfolio. The next thing is the concept of a rising tide lifts, or boats, and the opposite also tends to be true.

During the 2008 crisis, there weren’t too many stocks going up. Very vast majority of stocks were going down. Serial correlation dictates that that’s going to be the case. So, what we want to be doing here is aligning ourselves with the broader market. This concept of using a macro filter or an index filter, it’s nothing new. We’ve been personally using this concept since about 2001, but it’s an extremely potent tool. It’s been popularized in recent times in the book, ‘Dual Momentum by Gary Antonacci. It shows the significant research that I’ve done and other people have done, and across a different variety of strategies as well, not just momentum or trend following.

The probability of upside in a single stock continuing during our broader decline is very, very low. We don’t want to get involved when the broader market is going down. And the other benefit here, is that it provides a solid defence, and allows the portfolio to return to cash, and avoid sustained bear markets. So during 2008 for example, we literally sat in cash in this portfolio for the whole year, and other portfolios we came out, you know, during early parts of the year, but we sat on the sidelines for the majority of that decline. The way a macro filter works, is that we want the broader market to be trending up, and if it’s trending up, then we come down to the individual stocks, and we get involved with that. If the broader market is trending down, we do not want to be involved at all, simple as that. We want to see the individual symbol trending higher, but we also want to see the broader market, in case we use the S&P 500. We also want to see it trending up. This calculation doesn’t have to be overly complex, something simple, trading above a 200 day moving average, that will be appropriate, that will do the job. That’s a macro or an index filter, and we want to align our individual positions with the broader market.

Now the execution of strategies, we want to buy new companies, specifically those highest ranked stocks, and we want to exit weak companies and we don’t want to trade on the short side. Now we only do this process once a month, and that’s after the close of business on the last day of the month, we don’t rebalance during the month, we don’t have stop-losses during the month. On the very rare occasions, we’ll make a discretion or decision to rebalance, if there’s some kind of extraordinary discrepancy, in our position. Now, this has happened only once to me, and it was recently with Nvidia, Nvidia was the code. Profits grew to such an extreme level that it skewed the portfolio by quite a large margin, and we did cut that position back a little bit. Our rebalance function could be built into the strategy, it could be back-tested, but our research has suggested there’s no meaningful advantage from rebalancing a great deal. Some people, some components say you should rebalance weekly or fortnightly, all we found is it really didn’t make a big difference to the bottom line, all it did was create more trading, more commission, and more paperwork. So, we choose to do no rebalancing, and we only add to positions or remove positions, at the end of each month.

Let’s take a look at a summary here of what we’ve just been through. Firstly, we want to define the momentum somehow, linear regression, rate of change, few ways to do it. We want to pick a look back period, 12 months is what we use. We then want to rank the stocks strongest to weakest. We want to ensure that the trend of the stock, and the trend of the broader market are both up, calculate your position size, then you buy the strongest stocks, that’s done at the end of the month. If an existing position you have, has fallen out of that strongest rank, you sell it. Simple as that. If the broader market trend is down at the end of the month, you exit all positions and revert 100% of cash. So, you’re going to be fully invested, or fully in cash, that’s pretty well the way it works, and you just repeat that each month.

Now, let’s take a look at the performance. What we’ve got here is a broader portfolio, where we’ve used either a risk parody, which generally runs between 18 and 20 odd positions, 22 positions at any given time. Or a fixed percentage, and in this particular example, we’re using 20 positions, each allocated 5% of equity. You can see in both cases, significant outperformance of the S&P 500, fixed percentage has done a little bit different, a little bit better. But all in all, they’ve both done very, very well over the extended period of time.

The other benefit is you can see is that we sat in cash during that 2008 crisis. Now this does not include any interest earned on cash, it does not include any dividends either. During that period of time, we actually would have made a very, very small gain, albeit not much. But still, we didn’t lose a great deal of money. Financially that’s obviously a good thing, but also psychologically it’s a much better thing, because when the market does turn around, we’re going to have our confidence, and we’re going to be able to get involved again.

I still have people come to me, who lost a lot of money during 2008, and they still cannot get involved, they are still frightened to get involved in the market. If you have a strategy that you know, and you can rely on, that’s going to get you out of the market, when things go pear shaped, you’re going to be a lot happy, to be involved in the market during the good times, and that’s all we’re trying to do here. We want to be involved in the market during the good times, and we want to be out in the market during the bad times. That’s exactly what momentum does for us, and it does it automatically.

Let’s go one step further. If you want to turn yourself into a crazy data scientist, and test small,  here’s a few ideas worthy of pursuing. Now we use these in various aspects, across a variety of our systems, and they may add some value to your own research, but all of these ideas require more research and testing before implementation. Our research shows that large gaps, and I’m talking gaps in excess of 25% here, tend to reverse the momentum or at least stagnate the trend.

You can see an example here in Best Buy has a few gaps. Whilst the longer term trend did persist, there were extended periods of sideways trading activity, and they occurred after those large gaps. If we can filter those out, and potentially put our capital to work, rather than sitting in a stock, that’s doing nothing for three, four, five, six, seven months. We can point our capital to stocks that are showing much stronger momentum, and we put our capital to work in those ones rather than sitting around in these ones here. The next thing here is looking at, well what we’ve got here is relative momentum, which measures symbols against other symbols.  

Another technique that we’ve found to be useful, is to actually measure and rank the relative strength of the symbol to that of the underlying index itself. In this example, we’re measuring Broadridge Financial, against the S&P 500. When the indicator turns blue, we’ve got a sustained period of outperformance in the signal. Now, what we’re doing here, is we’re not looking at a single day, we’re looking at a period, we’re looking at a look back period, let’s say 10, 15, 20 days. We want the symbol to be outperforming index, over an average period of time. In 10, 20 days, something like that, then we rank it, and that can make quite a significant difference. This is also very, very good for trend following systems as well. It keeps you out of those quick price spikes. You know, those stocks that you see jumped very quickly and reverse just as quickly. We’ll make sure that you only capture sustainable trends and what it does is remove a lot of those quick spikes that turn around very, very quickly.

One way to rapidly increase performance, is taking a more concentrated approach to the portfolio rather than the classically diversified portfolio. Now, I liken this concept to the Goldman Sachs high conviction portfolio, where they choose the best of the best stocks, and pile into just a few. Now, whilst you will get higher growth, it does come with higher volatility.

This example right here, you can see you’ve got much better growth there. But this concentrated portfolio has 30% higher level of volatility. Now that’s not to be confused with drawdown, it just means the swings in the account on a day to day, week to week, month to month basis, will be a lot larger and you need to be able to wear those in order to get the performance. If you can’t wear the volatility, you’re not going to be there when that upside performance comes along.

Our trade long term portfolio takes a very concentrated view, and that’s why we’re able to get very high performance. This one is a very handy addition, and can greatly boost profitability, and greatly reduced trade frequency.


Let’s assume that our portfolio is going to initially buy the 10 highest ranked stocks. So that’s these 10 right here. After that green line. We’re going to buy those 10. Now using a classic example, that we’ve discussed today, at the end of the month, if one of these stocks drop below the green line, let’s say for example, let’s say Kroger for example, loses momentum, and it actually drops to the number 11 spot. Under normal circumstances, we would sell Kroger and we would buy whatever stock comes into the top 10. Let’s say for example, CA then comes into the top 10. So we sell Kroger buy CA, CA’s in the top 10, Kroger’s out of the top 10, Kroger’s out, CA’s in. Simple as that, that’s what we’ve been doing. I’m going to throw a little spanner in the works, and do it a little bit differently. Now this does boost profitability. So, in this particular case, let’s take Kroger again, instead of Kroger dropping out of the top 10 in order to sell it, we actually want it to drop all the way out of the top 20. So, it’s momentum has to reverse a lot more. As a result, we’ll tend to hold it a lot longer. That allows us to ride trends a significant period of time, longer than what we’ve had before. Something a little bit different. We want this exit rank lag, instead of dropping out of the top 10, we want an exit to drop out of the top 20, as an example. Greatly enhances profitability, well worth exploring further.

So, you can see here, the difference between a regular rank exit in the blue line, and the lag rank that we’re just talking about. In this particular case, our annual turn moves from 16% per annum, up to 20%. That’s mainly due to holding winners that little bit longer. And the win loss ratio also rises from about 1.3 out to 1.63 in this example. Trade frequency drops from 255 down to 177. You’re paying less commission, doing less paperwork, and less work. The drawdown actually also drops from 27 down to 26% as well. So significant benefits in using that lag.

Further Reading & Resources

  • ‘Dual Momentum’, a very popular book using ETF.
  • ‘Stocks on the Move’, Clenow, very similar to what we’re talking about here.
  • The Chartist, if you’re interested in getting contact with me, take a look at tradelongterm.com. We provide free watch lists, free momentum watch lists, register on the website, no credit card required, you can register for free, they’re updated every single week. We ranked the top S&P 500 stocks, and we also ranked the top US sectors as well.
  • Got any questions? Email me at, nick@tradelongterm.com.
  • Follow me on Twitter, @thechartist