Momentum Without Sudden Moves
Understanding the Frog-in-the-Pan Hypothesis
Introduction
Those who read my articles on investing and trading know that I’m a big fan of momentum trading. But not all momentum strategies are same. Some are better than others. What makes a momentum strategy better or of higher quality than its peers? Can we make returns of a momentum strategy smoother and steadier? Though we don’t know why the momentum factor exists, the more important fact for us is that we know that it exists and we want to exploit it to profit from financial markets.
Frog in the pan
There are several ways to improve momentum trading. In this article I’ll look at frog-in-the-pan hypothesis. Frog-in-the-pan theory states that investors tend to pay less attention to information which comes continuously and in small amounts. What this means is that gradual, run-of-the-mill information, news or changes are less attractive than occasional significant news.
If we apply this hypothesis to financial markets, we can suggest that the assets that rise (or fall) in prices gradually will show a better or high-quality momentum than those whose prices overreact to some news and increase (or decrease) dramatically in a short time. This can be because the latter tend to display mean-reverting behaviour after the initial “hype”. Once markets absorb the news, investors find out that it was in fact “much ado about nothing”, and the meteoric rise is followed by a steep decline which…
