Momentum trading and trend following are two popular trading strategies that may look similar on the surface. While both approaches focus on price, trends, and exit points, they also differ significantly in their underlying principles and execution. In this article, we enlisted the help of Marco Santanche, a quant strategist and author of the weekly newsletter Quant Evolution, to examine the key differences between momentum trading and trend following.
Difference No. 1: The Underlying Asset Classes
The most apparent distinction between the momentum and time series lies in the asset classes employed to formulate each factor. Momentum, as an equity style factor, is constructed using individual stocks. For instance, a momentum strategy might involve going long Nvidia and short Intel. On the other hand, trend following, being a macro style factor, is implemented by using derivatives across various macro asset classes including equities, fixed income, currencies, and commodities. For example, a trend following strategy might entail going long Nikkei 225 futures and going short crude oil futures.
Difference No. 2: Cross-Sectional vs. Time Series Momentum
“Another crucial distinction between momentum trading and trend following is the way they analyze and utilize momentum,” says Santanche in his newsletter. Momentum trading predominantly employs a cross-sectional approach, where assets are ranked based on their relative strength compared to others within the same period.
Read More: Trend Following ETFs: A Deep Dive
Traders aim to identify the strongest performers and capitalize on their short-term momentum, seeking quick profits. Santanche suggests, "I would normally add an overlay to that, for example, investing in the top-performing long and bottom-performing short only if the signs are positive and negative, respectively. However, it is an optional rule that one can choose to implement or not."
In contrast, traders implement trend following with various approaches, including time series momentum, which focuses on the historical price movements of a single asset over time. Instead of comparing the performance of different assets, trend followers analyze the price trajectory of a specific security to identify and ride sustained trends. This time series approach aligns with the more extended holding periods characteristic of trend-following strategies.
To illustrate the variance between cross-sectional and time series momentum, consider a simple example involving the construction of a momentum factor with only two assets: Microsoft and Tesla . Their momentum, defined by their past performance, looks as follows:
Microsoft: -8%
Tesla: -12%
In a cross-sectional momentum approach, a trader will long Microsoft and short Tesla, as Microsoft has outperformed Tesla. On the other hand, a time series momentum approach would involve selling both stocks due to their shared negative momentum.
Difference No. 3: Entry and Exit Criteria
“Momentum is typically scanned periodically, and there is usually no entry or exit until the next rebalancing date,” explains Santanche. “We update our basket of stocks that are out/underperforming, and we eliminate those in between, if necessary. On the other hand, trend following seeks entries and exits; the entry requires the trend to be established, so it might happen at any time, and the exit can vary depending on the implementation, but it usually results from assessing whether the trend is over or never existed.”
It's worth noting that there are occasional suggestions that RSI and MACD can be employed for identifying momentum, but this is a misconception as RSI and MACD have little connection to momentum. Although some might use them as filters, it’s an uncommon practice.
“The pure entry signal is identified periodically by assessing the performance of the assets,” says Santanche. “Traders can choose to enter or not based on specific filters. For instance, momentum might be required to be significant, such as 10%, or it could be relative to the cross-section (mean or median of the returns of the assets in baskets), ensuring it's 10% above the cross-section.”
Difference No. 4: Time Horizon and Holding Period
One of the differences between momentum trading and trend following lies in their respective time horizons and holding periods.
“Momentum trading typically operates on a shorter time scale,” remarks Santanche in his weekly newsletter. “This is attributed to its usual implementation, involving the periodic scanning of top and bottom-performing stocks. Such an approach may prompt exits in certain positions if their momentum inverts or fails to remain significant.”
Conversely, trend following often adopts a longer-term perspective, concentrating on capturing more extensive and sustained trends in the market. Practitioners of trend following are recognized for holding positions over extended periods to fully capitalize on the magnitude of a trend.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
