What is a momentum crash and why does it happen ?

It's quite a daft premise really but, in general, constructing a portfolio full of stocks that have risen the most over the previous year or so gives you the highest probability of making a profit in the coming months. Between the end of WWII and 2008 a strategy that went long recent winners and short recent losers (i.e. top and bottom 10% of stocks ranked by 1 year price performance) returned an annualised 16.5% with remarkably low volatility. So strong is the return to these long-short momentum strategies and so universally is it witnessed across sectors and asset classes that billions are allocated to it by fund management groups globally.

Victor Niederhoffer, the famous quantitative trader, once poetically described statistical trading strategies such as this as 'like collecting nickels and dimes in front of a steamroller'. Indeed, hidden within the smooth and strong profit line of this momentum strategy lurks a black swan with a nasty bite. It displays what is known as 'negative skewness' - every once in a blue moon profits from the strategy completely and utterly collapse, wiping out careless traders in the process.

What happens in a momentum crash

In April 2011 Kent Daniel published the research paper...