Momentum Trading: The New Alchemy

BRUCE I. JACOBS

BRUCE I. JACOBS is ech stocks made phenomenal gains and sell stock as its price declines, limiting a principal of Jacobs in 1999 and early 2000, more than their downside. Levy Equity Manage- doubling in just the ten months In essence, momentum traders today are ment in Roseland, NJ. He holds undergradu- leading up to their peak in late trying to obtain the benefits of a call option— TMarch, and outstripping the Old Economy upside participation with limited risk on the ate and graduate degrees from Columbia S&P 500 by more than 150% on an annual- downside—without payment of an option University, an M.S.I.A. ized basis. While the ride to the top of this premium. These traders buy as stock prices from Carnegie-Mellon market seemed much faster than a roller coast- rise, often financing their purchases with mar- University’s Graduate School of Industrial er’s labored ascent, everyone knows the top of gin debt borrowing. Further price advances Administration, and the ride is followed by those dips and loops lead to more borrowing and more buying. M.A. and Ph.D. degrees that churn one’s stomach. It seemed inevitable When prices fall, momentum traders expect from the University of that something would have to give. How to be able to limit their downside by selling. Pennsylvania’s Whar- much longer could companies paying no div- Provided sales can be executed quickly, ton School. He is the idends, with no earnings in sight, support in liquid markets, the strategy appears to offer author of Capital Ideas and Market Realities: stratospheric prices? a lot of upside with not much downside. And, Option Replication, Yet, as tech stocks soared, momentum with trading on the Internet now vying with Investor Behavior, and investors kept buying and buying. Why? Alan long-distance telephone service for price com- Stock Market Crashes. Greenspan has likened these hot stocks to lot- petitiveness, it’s pretty cheap to boot. tery tickets; investors apparently ignore the Furthermore, the strategy is easy to odds stacked against them in the hope of win- implement, especially compared with tradi- ning the big prize. In fact, the driving force tional security analysis. After all, trying to behind market movements today might be determine the worth of a company requires better understood by reference to option pric- devoting a great deal of time and effort to ing theory, and the way some option-like research. All momentum investors have to do strategies seem to offer the promise that they is repeat the mantra, “The trend is your can turn base metal into gold. friend.” When Fischer Black, Myron Scholes, A chance of huge gains with little risk and and Robert Merton cracked the option pric- minimal cost—no wonder every man, woman, ing code in 1973, they also offered a formula and child in America seemed to jump on the investors could follow to attempt to replicate momentum bandwagon. And no wonder so the payoffs on options. For call option repli- many felt empowered to enlarge their stakes via cation, investors borrow to buy stock as prices borrowing. By the end of March, margin debt rise, capturing the upside of price movements, had ballooned to a record $278 billion.

6 MOMENTUM TRADING: THE NEW ALCHEMY WINTER 2000 So what can go wrong? In essence, momentum to markets, arbitrage trades are inherently stabilizing, investing sows the seeds of its own destruction. As more working to narrow mispricings. Yet, like portfolio insur- and more of the market’s capital becomes concentrated in ers and momentum traders, LTCM was overconfident in this type of strategy, market stability becomes increasingly the safety of its strategy. The global diversification of tenuous. Rising prices encourage more buying, and more LTCM’s trades and their offsetting nature were presumed borrowing, which raises prices further. Eventually, prices to provide an initial defense against unexpected price reach such a delusional height that the merest whiff of bad moves. news is capable of deflating them. LTCM piled on huge amounts of leverage, via bor- At this point, the market becomes susceptible to dam- rowing and low-margin derivatives, which allowed the age from the momentum strategy’s “fail-safe” mechanism. hedge fund to magnify minuscule profit margins on each That is, with substantial capital riding on momentum strate- trade into stellar gains on gargantuan positions. When gies that are poised to cut and run when the going gets Russia defaulted in August 1998, however, LTCM’s highly tough, the slightest price decline can result in an avalanche leveraged, low-cost, low-risk trades suddenly turned of sell orders. Concentrated selling by momentum investors extremely risky. The hedge fund faced massive margin pushes prices downward. As prices fall, of course, margin calls, and found neither investors nor lenders willing to calls lead to further selling pressure, forcing more sales into supply the needed liquidity. At this point, its only recourse already declining markets. Momentum selling panics other was to the same loss-limiting solution used by portfolio investors and crushes market values. insurers and momentum traders—the sale of assets into a Only then does the real cost of the strategy, to its fol- declining market. With markets already in turmoil, the lowers and to investors generally, become known. threatened liquidation of LTCM sent market volatility Momentum traders find they cannot exit their stocks so soaring to levels not seen since the 1987 crash. easily, or cheaply. Rather, they sell out at prices much Strategies that appear to offer the rewards of invest- lower than they may have expected. Their “riskless” strat- ing without the risks are almost irresistible, and when they egy suddenly becomes very risky. Meanwhile, other appear low-cost as well, they probably are irresistible. investors find that their equity holdings are decimated. After all, investors, being human, are greedy for gains and Today’s momentum trading has retraced the paths of fearful of losses. Unfortunately, as such strategies become other strategies that seemed to offer the formula for cre- more successful at attracting capital, their fail-safe mech- ating gold but in reality held only the formula for destroy- anism for limiting losses becomes less likely to work, and ing market value. In the 1980s, portfolio insurance more and more likely to wreak havoc on markets. attempted to replicate a protective put option offering We witnessed this most recently in April 2000, upside gains with a floor on downside losses (see Jacobs when the momentum-driven tech sector collapsed, driv- [1998]). Again, the formula called for buying stock as stock ing some highly leveraged investors into bankruptcy and prices rose and selling as prices fell. As with the call sending others scurrying for the exits. Let’s hope it doesn’t option replication of momentum investors, portfolio take an even bigger catastrophe for investors to recognize insurance investors paid no premium at the outset of the the real cost of momentum strategies today. strategy. Furthermore, they could execute the strategy in futures markets for a fraction of the cost spot market REFERENCES trading would incur. The promise of high return potential with limited Jacobs, Bruce. “Option Pricing Theory and its Unintended losses at minimal cost had attracted tens of billions of pen- Consequences.” The Journal of Investing, Spring 1998. sion dollars by mid-1987. But when the market began to decline in October of that year, much of the equity in ——. “When Seemingly Infallible Arbitrage Strategies Fail.” portfolio insurance programs ended up abruptly dumped. The Journal of Investing, Spring 1999. Stocks fell 22% in one day, October 19. In the 1990s, Long-Term Capital Management used option-based models to seek out and exploit arbitrage opportunities across the globe (see Jacobs [1999]). Unlike the trend-following trading of portfolio insurance and momentum investing, which are inherently destabilizing

WINTER 2000 THE JOURNAL OF INVESTING 7 Reprinted with permission from the Winter 2000 issue of The Journal of Investing.