How to Study and Automate Dual Momentum Trading Strategies.
When we talk about the study and development of Trading and Investment strategies, we usually think of factors such as the trend and its strength, also known as Momentum, to carry out our studies about Market Timing and Analysis.
At least this would be the most common approach on Financial Markets and Time Series Analysis.
The problem with this approach is that we measure the trend of a single asset, and not a global set, so if we find that all equity assets are increasing, we will not know which one to buy, or worse, we will buy at random without having a remote idea of how the events can end, think of a financial bubble.
To solve this type of problem, strategies based on Dual Momentum were born, let’s see what they are about.
What is the Momentum Indicator
In order to talk about Dual Momentum, first we need to know the classical approach to this strategy, using a single momentum indicator, or formula if you want to be more precise to understand how the market is performing.
So, the Momentum Indicator is really similar to Time Series integration, a really interesting concept of Quantitative Trading, in this case. We are extracting the percent return of the current price compared to a certain period, the formula is the following.
Momentum: Current Price / Price of desired period, usually 14.
There are certain variations to this formula, usually some trading platforms multiplies the result by 100. I don’t know the reason why.
How is the Momentum Indicador used
Usually, the most popular strategy will be buying an asset once its value crosses over 100 or 0, according to our platform.
in this case we are approaching an Autocorrelation model based on the premise that, if my asset was going up, it will continue to go up. And there’s a problem with this approach on certain types of Assets as Forex, where we don’t have long trends that last more than a year.
So, the first solution that traders thought was to compare a Momentum Indicator against other.
What happens if the 7 period indicator is greater than the 14 period one? We have a buying signal?
So, it is valid and profitable to trade this way? What happens if we start comparing the values of other financial assets?
You can guess it, If we use the classic approach we are going to be really reliant to the capability of autocorrelation of financial assets, and in Forex this will end to be a disaster since long term trends are something unheard of, expect for Venezuelan Bolivar and Argentinian Pesos.
Before continuing, I will like to invite you to test this classic approach to the market to see how it performs in different types of Assets. As you can see, this will perform very differently in Financial Index instead of using Forex.
Anyway, for Dual Momentum we are going to use both.
What is Dual Momentum
We can say that a Trading Strategy uses Dual Momentum if compares the current trend of two or more financial assets. The definition may vary depending on who you ask, especially in the part of more than two assets. I still prefer to not limit myself using only to assets when i’m creating an Investment Portfolio or a Trading one.
Let’s see a basic flowchart of a Dual Momentum signals.
As we can see on the flow chart, our Dual Momentum strategy begins with computing the momentum of two separated assets, and we are going to compare them against each other.
If Signal 1 Momentum’s is greater than Signal 2, then we are going to buy the Asset 1, otherwise we will buy the Asset 2.
We can add more rules and score metrics to make this model more precise, but for now, let’s stick with it.
As you can see, this is a very simple programming logic.
How to Trade Dual Momentum Strategies
First of all, we are going to need two or more assets to create a small universe of tradeable products, maybe ETFs, Stocks or even Forex Pairs as a safe haven protection.
Once we have our assets we need to compare them, so we need to calculate the Momentum for every asset in our list.
Then, we will need to process the signals of each one.
Dual Momentum = Momentum of Asset 1 – Momentum of Asset 2
If we have more assets then we are going to create a different diagram where we compare each value to extract the greater one.
This is a very similar approach to Intermarket Trading Strategies.
Dual Momentum Trading Strategies
Once we have have every data transformed to what we need, it will be time to perform some Dual Momentum Backtests to study the market and see how it performs.
In this case, I’m going to pick some simple assets, some Forex Pairs, Financial Indexes and maybe Metals.
Trading Strategy: DAX30 and EURUSD
In the picture above we can see a Backtest of this Strategy, this one is really simple, using a Monthly Time-Frame, we calculate this:
Last Month Return of DAX30 – Last Month Return of EURUSD. If our result is positive we will buy the DAX30 Index for one month, otherwise, we will buy EUR/USD.
Why this strategy works and over-performs the index?
Let’s start from the beginning, from a purist point of view, investors doesn’t open positions in the Forex Market, so most people doesn’t know how Macroeconomic events impact both the Stock Market and the Currency Markets.
If the Euro starts appreciating, rising its value, this means that the German economy will be impacted in terms of exportation, so companies will perform bad, while the own Euro is rising on its value.
Remember that in some cases, we will benefit purely from the low volatility that currencies have. Meaning that while the DAX30 is down a 5% in a Month, EURUSD will be only down a 2%.
So, in this case we will be profiting of that.
Certainly we have more interesting strategies, and some of that will be covered later. Now we are going to focus on how to improve our models and do some research.
How to research this strategy and how to automate it?
In order to research this strategy I just use Excel and some scripts made in Java, since most platforms won’t allow to make a multi-asset backtest, so we are going to need to be more creative.
Otherwise, even the platforms that doesn’t allow us to perform backtest they allow us to automate them, platforms like Tradestation or Metatrader 4 will do the trick.
Remember that if you need to learn how to code you can check my free courses on youtube:
In order to improve this strategies we can develop some filters based on the previous trend, for example, instead of a Momentum of 1 period, maybe we can create a score from 1 to 3 periods.
This kind of Trading and Investment Strategies can beat the market really easily if you find the correct assets, or create a huge model based on dozens of sectors, countries and types of asset, mostly the Stock Market and Fixed Income.
I love to use some Forex Pairs to create powerful trading strategies combined with Stock Indices and then trade them with Futures and ETFs to grow my portfolio over the time.
As always, hope this article can help you improve your trading.
Víctor – Follow the Edge.