Dual Momentum Trading

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Written By
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

Dual Momentum Trading is a trading strategy developed by Gary Antonacci that combines two types of momentum:

  • relative momentum and
  • absolute momentum

This strategy tries to capture the benefits of both types of momentum to improve returns and reduce risk.


Key Takeaways – Dual Momentum Trading

  • Dual Momentum Trading combines relative strength momentum and absolute momentum to identify the strongest assets and market conditions for trading oroptimal portfolio allocation.
  • It involves regularly rotating into the top-performing assets while also maintaining exposure to an asset class only when its long-term trend is positive.
  • This approach tries to capitalize on persistent trends while managing downside risk
    • Can potentially enhance risk-adjusted returns over the long run.
  • We give an example to illustrate how to implement a Dual Momentum Trading strategy by selecting, evaluating, and executing trades based on relative and absolute momentum criteria.


Relative Momentum

Relative momentum – also known as cross-sectional momentum – involves comparing the performance of different assets against each other over a specific period.

The assets that have performed the best over this period are selected for trading.

This approach is based on the idea that assets that have performed well in the recent past will continue to outperform in the near future – i.e., essentially the idea of momentum trading.

How to Implement of Relative Momentum

  1. Selection of Assets – Choose a universe of assets to compare, such as stocks, bonds, or commodities.
  2. Performance Measurement – Measure the performance of each asset over a defined look-back period, typically 3 to 12 months.
  3. Ranking – Rank the assets based on their performance during the look-back period.
  4. Trading Decision – Select the top-performing assets for trading/investment. The number of selected assets can vary based on the strategy’s design.


Absolute Momentum

Absolute momentum, also known as time-series momentum, compares an asset’s performance to its own historical performance.

If the asset’s recent performance is better than a threshold (often its average performance over a look-back period), it’s considered to have positive absolute momentum.

Implementation of Absolute Momentum

  1. Performance Evaluation – Assess the asset’s return over a look-back period, such as the past 12 months.
  2. Threshold Comparison – Compare the asset’s return to a predetermined threshold, which could be a risk-free rate or zero.
  3. Trading Decision – If the asset’s return exceeds the threshold, it’s considered for trading. If it falls below, the asset is avoided or sold.


Combining Relative and Absolute Momentum

Dual Momentum Trading combines the principles of relative and absolute momentum to improve the robustness of the strategy.

Generally, the more you have going for a trade the more likely it is to perform.

By doing so, it aims to achieve better risk-adjusted returns.

Steps to Implement Dual Momentum Trading

  1. Relative Momentum Screen – Apply the relative momentum criteria to identify the top-performing assets from the selected universe.
  2. Absolute Momentum Screen – Evaluate these top-performing assets using absolute momentum criteria to ensure they’re also performing well relative to their own history.
  3. Final Selection – Trade/allocate to the assets that pass both relative and absolute momentum screens.


Benefits of Dual Momentum Trading

  • Risk Reduction – Incorporating absolute momentum can help the strategy avoid allocating to assets during periods of negative performance and reduce drawdowns.
  • Enhanced Returns – The combination of relative and absolute momentum helps to capture the best-performing assets while avoiding underperformers. Can potentially lead to higher returns.
  • Diversification – Dual momentum can be applied across various asset classes. Provides opportunities for diversification and reducing portfolio volatility.


Example of Dual Momentum Trading Strategy

  1. Asset Universe – Consider a universe of global equities and bonds.
  2. Relative Momentum – Rank these assets based on their performance over the last 12 months.
  3. Absolute Momentum – Compare the performance of the top-ranked assets to the risk-free rate.
  4. Decision – Allocate to/trade the top-performing assets that also have positive absolute momentum, while moving to cash or bonds if the momentum criteria are not met.

Let’s look at some trades involving Dual Momentum.

To illustrate Dual Momentum Trading with specific trades, let’s use a simplified example involving three asset classes:

  • US equities
  • international equities, and
  • bonds

We’ll assume a portfolio value of $100,000 and use a 12-month look-back period for both relative and absolute momentum.

Step-by-Step Trade Implementation

Step 1: Selection of Assets

Choose a universe of assets:

  • US Equities – Represented by the S&P 500 Index ETF (SPY)
  • International Equities – Represented by the MSCI EAFE Index ETF (EFA)
  • Bonds – Represented by the U. Aggregate Bond Index ETF (AGG)

Step 2: Measure Relative Momentum

Calculate the 12-month performance for each asset:

  • SPY: 15% return
  • EFA: 10% return
  • AGG: 7% return

(These are just example returns.)

Rank the assets based on their performance:

  1. SPY (15%)
  2. EFA (10%)
  3. AGG (7%)

Step 3: Measure Absolute Momentum

Compare each asset’s performance to a risk-free rate (e.g., the 12-month Treasury bill rate, assumed to be 5%):

  • SPY: 15% (greater than 5%) – Positive absolute momentum
  • EFA: 10% (greater than 5%) – Positive absolute momentum
  • AGG: 7% (greater than 5%) – Positive absolute momentum

Step 4: Final Selection and Trade Allocation

Select the top-performing assets with positive absolute momentum. In this case, all three assets meet the criteria, but we will prioritize the highest relative momentum assets.

Allocate the portfolio as follows:

  1. 45% to SPY (highest relative momentum)
  2. 30% to EFA (second highest relative momentum)
  3. 25% to AGG (third highest relative momentum)

Step 5: Execute the Trades

Based on the $100,000 portfolio, the trade amounts are:

  • SPY: $100,000 * 45% = $45,000
  • EFA: $100,000 * 30% = $30,000
  • AGG: $100,000 * 25% = $25,000

Step 6: Placing the Orders

Place the following trades:

  1. Buy SPY
    • Order type: Market order
    • Quantity: $45,000 / SPY price (assume SPY price = $450)
    • Quantity: 100 shares
  2. Buy EFA
    • Order type: Market order
    • Quantity: $30,000 / EFA price (assume EFA price = $75)
    • Quantity: 400 shares
  3. Buy AGG
    • Order type: Market order
    • Quantity: $25,000 / AGG price (assume AGG price = $100)
    • Quantity: 250 shares


Monitoring & Rebalancing

  • Monthly/Quarterly Review – Review the portfolio every month or quarter, re-evaluating the momentum criteria. For more active day traders or swing traders, you can monitor more frequently.
  • Rebalancing: Adjust the portfolio based on the latest momentum rankings and performance to maintain the desired allocations.