Last Updated on 7 April, 2022 by Samuelsson
The momentum factor has been known to exist in many asset classes, especially equities and equity indices. It is a well-known and robust anomaly in the market and has been well-researched by institutional traders and academics. Interestingly, many traders have been exploiting this powerful anomaly.
There are many papers on the momentum strategy in the equity market, but only a few about the momentum factor in the currency market. In this post, we explore the currency momentum factor, but first, let’s find out what momentum really means.
What does momentum mean in trading?
In trading, the concept of momentum is the tendency of an asset price to continue moving up or down until it is forced to change direction by a significant force or event in the market. In other words, it is the tendency of an asset’s price to be in a trend for a considerable period. Thus, momentum is a trend-following strategy.
In momentum investing, the aim is to buy securities that have been showing an upward price trend or short-sell securities that have been showing a downward trend. As you would expect, the rationale behind momentum investing is that once a trend is well-established, it likely to continue. That is, momentum investors believe that trends can persist for some time and that it’s possible to profit by staying with a trend until its conclusion, no matter how long that may be. For instance, the trend that started in the U.S. stock market in 2009 continued until 2020 when the coronavirus pandemic emerged.
However, momentum investors don’t just buy one asset and leave. While they buy top-performing assets and sell badly performing ones, they have strategies that stipulate how often they reassess the market to reallocate their funds into the best-performing assets (long positions) and the worst-performing assets (short positions).
Unlike fundamental or value investors, momentum investors are not concerned with fundamental factors — in the case of a stock, the company’s earnings — because momentum investing is strictly a technical trading strategy. All they do is use technical indicators to identify trends and gauge the strength of the trend (price momentum).
Now that you know what momentum means in financial trading, let’s consider some research findings on the momentum factor in currency trading.
Understanding how the momentum factor works in currency trading: what the papers say
As you would expect, there is a momentum anomaly in the currency market, and it can provide a huge edge to forex traders if exploited the right way. It has been established that the exchange rates of currency pairs trend on a multi-year basis; thus, a strategy that follows the trend can make positive returns over time.
So, what are the findings of financial institutions and academics?
In their global foreign exchange report, Deutsche Bank showed that momentum is a component of their trading strategies. The report showed how the three components — carry, momentum, and valuation — and their unified strategy, DBCR, performed over a period of 20 years: from 1989 to 2009. See the chart below.
From the table below, you can see that the momentum strategy offered 7.61% in annualized total return, with an annualized volatility of 10.22% and a Sharpe ratio of 0.30. Momentum had the best Biggest Monthly Gain and one of the best Mean Monthly Returns.
In the paper titled “Currency Momentum Strategies”, Menkhoff, Sarno, Schmeling, and Schrimpf, provided a comprehensive empirical investigation of momentum strategies in foreign exchange markets, covering more than 40 currencies within the period from 1976 to 2010. They noticed a significant cross-sectional difference in excess returns of up to 10% per annum between the past winner and past loser currencies. This establishes the fact that currencies with high recent returns continue to outperform currencies with low recent returns by a significant margin.
As with momentum in equity markets, this difference in excess returns could not be explained by traditional risk factors, and it showed behavior consistent with investor overreaction and under-reaction. Expectedly, momentum in the currency market is mostly driven by return continuation in spot rates, rather than interest rate differentials, and has very different properties from the widely studied carry trade. But there seem to be effective limits to arbitrage, which prevent momentum returns from being exploitable in foreign exchange markets. One of such is that momentum portfolios incur large transaction costs and are heavily skewed towards currencies with high idiosyncratic volatility and high country risk.
In the paper, “Is Momentum in Currency Markets Driven by Global Economic Risk?”, Grobys, Heinonen, and Kolari investigated the potential link between momentum in currency returns and global economic risk as measured by currency return dispersion (RD). They established that there is a robust link between the returns of the momentum anomaly implemented in currency markets and global economic risk (measured by the currency return dispersion (RD)). Their work showed that the spread of the zero-cost momentum strategy is significantly larger in high RD states (worldwide crisis states) compared to low RD states. In addition, they found that the relation between these momentum payoffs and the global economic risk appears to increase linearly in risk. Given this evidence, they concluded that global economic risk, as represented by RD, helps to explain currency momentum profits.
Bianchi, Drew, and Polichronis — in their work titled, “A Test of Momentum Trading Strategies in Foreign Exchange Markets: Evidence from the G7” — tried to answer three key questions: (1) does momentum exist in foreign exchange markets?; (2) what is the impact of transactions costs on excess returns?; and (3) can a consolidated trading signal garner excess returns and, if so, what is the source of such returns? By using total return momentum strategies in the foreign exchange markets of the G7 for the period 1980 through 2004, they arrived at the following answers: (1) there was evidence of momentum, but such momentum appears transitory, especially for longer look back periods; (2) transaction costs have a material negative impact on excess returns; and (3) while a consolidated signal garners excess returns, a bootstrap simulation found that the source of these returns is a function of autocorrelation.
Finally, according to Filippou, Gozluklu, and Taylor — Global Political Risk and Currency Momentum — the global political environment affects all currencies, and investors who make use of momentum strategies are compensated for the exposure to the global political risk of those currencies they hold (the past winners), while the ones they sell (past losers) provide a natural hedge. Thus, global political risk is priced in the cross-section of currency momentum, but it contains information beyond other risk factors.
Why momentum works
According to academics, the main reason why does the momentum anomaly work is the irrationality of investors. In other words, investors act irrationally in the market, either underreacting or overreacting to the new information or failing entirely to consider news in the prices.
In fact, according to Menkhoff, Sarno, Schmeling, and Schrimpf, currency momentum is mostly driven by return continuation in spot rates (instead of interest rate differentials) and has very different properties from the widely studied carry trade.
However, another possible explanation could be that momentum occurs because experienced investors are exploiting behavioral shortcomings, such as investor herding, investor over-reaction and under-reaction, and confirmation bias, in other investors. Deutsche Bank’s global foreign exchange report, the segmentation of the currency market where some participants act quickly on the news while others respond more slowly is one reason why trends emerge and can be protracted. It likened using a long momentum strategy in the forex market to investing in a market-capitalization-weighted equity index, such as the S&P 500 Index.
Furthermore, in the paper titled, “Global Equity Correlation in Carry and Momentum Trades”, Bae and Elkamhi provided a risk-based explanation for the excess returns of two widely-known currency speculation strategies: carry and momentum trades. They constructed a global equity correlation factor to show that it explains the variation in average excess returns of both these strategies and that the global correlation factor has a robust negative price of beta risk in the FX market. They also presented a multi-currency model which illustrates why heterogeneous exposures to our correlation factor explain the excess returns of both portfolios.
Additionally, as we pointed out earlier, Filippou and his group have shown that the global political environment affects all currencies and that investors following momentum strategies are compensated for the exposure to the global political risk of those currencies they hold — in other words, they are compensated for holding the past winners, while past losers provide a natural hedge.
What about risks?
As we have seen so far, while risk can be used to explain some aspects of the returns from the momentum strategy, it does not explain everything because in some cases, the returns are in excess of what is anticipated for the level of risk. This may be why there are different hypotheses about the momentum anomaly.
While one hypothesis states that investors bear a significant risk when implementing a momentum investing strategy, so the potentially high returns are the reward that counterbalances that risk, another hypothesis suggests that momentum investors are leveraging the behavioral weaknesses of other investors, such as the tendency to “follow the herd” — a phenomenon that is also referred to as the “herd mentality bias”.
Why you should consider adding a momentum-based currency portfolio to your holding?
You can use it to hedge your stock portfolio during bear markets, and here is why. Momentum-based currency investment portfolios have a low correlation to the traditional equity market factor. As a result, you can profitably use a currency momentum portfolio to augment conventional equity-heavy asset allocation.
This opinion is supported by the findings of Grobys, Heinonen, and Kolari in their research paper “Is Currency Momentum a Hedge for Global Economic Risk?”, which shows that the currency momentum factor is a hedge for global economic risk.
Also, in the paper titled, “Currency Management with Style” Lohre and Kolrep argued that instead of approaching currency hedging with an all-or-nothing mentality — either full hedging of all foreign exchange (FX) positions or no hedging at all — a more nuanced approach would be to systematically harvest the benefits of the different foreign exchange style factors: carry, value, and momentum. They went on to demonstrate how these factors can expand the opportunity set of traditional asset allocation when pursuing either currency factor-based tail-hedging or return-seeking strategies.
How to apply the momentum strategy in currency trading
Here’s how to make use of the momentum strategy in currency trading and the tools you can use to measure momentum:
Creating a momentum strategy
To create and use a momentum strategy in forex, these are the steps to follow:
- Create a currency investment universe of about 20 or more currencies.
- Rank each currency by its 12-month spot return vs. the USD; alternatively, you can use a momentum indicator to rank the currencies.
- Divide your capital into two: one half for long positions and the other half for short positions.
- Allocate 1/3rd of your capital for long positions to each of the three currencies with the highest 12-month momentum against USD and go long on those three currencies.
- Allocate 1/3rd of your capital for short positions to each of the three currencies with the lowest 12-month momentum against USD and go short on those three currencies.
- Rebalance every month on your specified roll date.
Tools for measuring momentum
There are many tools you can use to estimate the momentum of the various currencies in your investment universe. These are some of them:
- Rate of change: It compares the current price level to what it was x time in the past.
- Moving averages: They measure the mean of the price as it moves in any direction.
- Stochastic: It compares an asset’s most recent closing price to the prices over a specified period.
- RSI: It measures the speed of price movement by comparing the up and down days over a specified period.
- ADX: It measures the strength of the trend (but not the direction) in a currency
- Moving average convergence divergence (MACD): It compares the difference between two moving averages with the moving average of that difference.
Related reading: Momentum Factor Effects in Country Equity Indexes
Related reading: Momentum Factor Effect in Stocks