Momentum and Reversal
Stocks that did well over the past few months tend to stay a bit stronger; but those that just shot up last month often give it back the next. The lookback period decides whether you're buying momentum or reversal.
Every lesson has an interactive simulation you can drag and play, plus a quick quiz. Sign up free to use them and save your progress automatically. Here is the text version of this lesson.
Not sure yet? Try the first lesson (no sign-up needed)「Building Strategies from Rule Blocks」。
Text version · Quant Basics, lesson 7: “Momentum and Reversal”
Stocks that did well over the past few months tend to stay a bit stronger; but those that just shot up last month often give it back the next. The lookback period decides whether you're buying momentum or reversal.
Do the strong stay strong?
Rank all stocks by their gains over the past few months, buy the top 20% and short the bottom 20%: that's winners minus losers. Historically it has made money on average, and it's the best-known momentum factor.
The latest month is the exception
Looking at just last month, the big winners often give some back. This is called short-term reversal (a short-term kind of mean reversion). That's why the classic approach looks at the past 12 months and skips the latest one.
Momentum can crash too
When the market rebounds sharply at the end of a bear market, the worst losers rally the hardest, and the long-short portfolio can lose years of gains in a month or two. This is called a momentum crash.
Key takeaways
- Cross-sectional momentum: buying the winners of the past 3–12 months and selling the losers has earned positive excess returns on average in historical data from many markets.
- Short-term reversal: looking only at the last month, big gainers tend to fall back, so the classic momentum signal "skips the most recent month" (12-1 momentum).
- Momentum can crash suddenly: when the market reverses sharply, winners and losers swap places and a long-short portfolio can lose heavily in a very short time.
- The market in the simulator is a parameterized illustrative model; real-world effects vary across eras and markets.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Default (12-month lookback, no skip): what's the average monthly long-short return? What share of months are winners?
- Set the lookback to 1 month: what's the long-short return now? Is it better to buy winners or losers?
- Turn on “Skip the latest month”: what's the average monthly return for the 12-month lookback now? How does the bar's color change?
- Turn off “Skip” and set “Short-term overreaction” to 0: is the 1-month lookback still negative?
Quiz and explanations
- 1. What does the classic "12-1 momentum" mean?
- Answer: Look at the past 12 months' return, but skip the most recent month.Skipping the latest month avoids interference from short-term reversal.
- 2. In a market with short-term overreaction, if you buy only the strongest stocks by last month's gain, what's most likely next month?
- Answer: They underperform on average, because short-term gains are often given back.Last month's "surprise" partly reverses. That's short-term reversal.
- 3. In a momentum long-short portfolio, the winners return +2.1% next month and the losers +0.6%. What's the long-short return for the month?
- Answer: +1.5%.Long the winners earns 2.1% and short the losers loses 0.6%, for 2.1% − 0.6% = +1.5% in total.
Terms in this lesson
- mean reversion (Mean Reversion): The tendency of a price or spread to drift back to its average after straying from normal.
- momentum crash (Momentum Crash): When the market reverses sharply, past losers soar and winners lag, so a momentum long-short portfolio loses heavily in a short time.
- momentum factor (Momentum): The tendency of stocks that have done well recently to keep outperforming in the near term.
- short-term reversal (Short-term Reversal): Stocks that rose most over about the past month tend to slip the next month and the biggest losers tend to bounce, often blamed on overreaction and liquidity shocks.
- winners minus losers (Winners Minus Losers): Ranking stocks by recent gains, buying the top group and shorting the bottom group to earn the return gap between them.