(Bloomberg) — Violent moves in the S&P 500 in January added insult to injury for a momentum trade that exploits the daily machinations of a stock market ever-more dominated by the machines.
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The good news: A JPMorgan Chase & Co. quant says a rebound is nigh now that Wall Street players are no longer plunging into the strategy in droves.
With automated investors like index funds a growing force on major exchanges, reliable day-to-day stock patterns are making a comeback, according to Peng Cheng at the U.S. bank. His intraday trend-following model is up this month by the most since June 2020.
“The environment is probably more favorable now for this strategy than in the last year or two,” the global quantitative and derivatives strategist said.
A JPMorgan index shows the trade enjoyed steady gains in the two years through 2019 and wrung up huge profits during key months of the pandemic, which were marked by consistent buying or selling. While the approach can come in many shapes and sizes depending on how quants model it, a Deutsche Bank AG gauge tells a similar story.
But the strategies have faltered since 2021 — likely a casualty of their own popularity, per Cheng’s latest research. And with the Federal Reserve expected to embark on faster rate hikes and Ukraine and Russia on the brink of war, the start of the year was marked by outsize volatility. The S&P 500 suffered four separate sessions of 1% intraday reversals in January, up or down.
Those kinds of moves work against intraday trend following by its very design. Systematic strategies, validated by back tests and touted for their appeal over the long-haul, can respond slowly to changing market conditions.
The challenge for intraday momentum also exemplifies Wall Street quants’ struggle for outperformance in an era where any trade that works is quickly publicized and packaged up into a product for clients.
Practitioners say the appeal of intraday momentum is based on a key idea backed by research: An asset’s early moves during the day can inform its direction for the rest of the session. As big money managers like leveraged exchange-traded funds balance their portfolios at the close, it increasingly strengthens the trend.
In Cheng’s model, for instance, the rules are simple: If the S&P 500 is up from the prior session’s close to 3:30 p.m., the trading program goes long. If the index is down during that period, it puts on a short. Then the money manager awaits the 4 p.m. bell and closes the position. The size of the wager depends on the strength of the signal — the bigger the move, the larger the bet.
Cheng sees two reasons for diminished returns of late. First, shifts in options hedging, with dealers increasingly stuck in “long gamma” positions since 2020. That leaves them needing to go against the prevailing equity trend to maintain a neutral market exposure.
Second, crowding. While it’s impossible to say how much cash follows the strategy, Cheng designed a model to track order flow imbalance of S&P 500 futures, or the difference between buy and sell trades, as a proxy for equity demand. At around 3:30 p.m. — the time to start the intraday trade — it tended to increase following a period of strong strategy gains, and it fell after a stretch of weak returns. The opposite was true for flows around 4 p.m., the time to exit.
To Cheng, it’s a sign that systematic traders doubled down after a stellar 2020, leading to subpar performance for the intraday strategy subsequently. The solution, he says, may be to diversify the timing of trades so they aren’t front-run by competitors.
At Societe Generale SA, strategist Abhishek Mukhopadhyay has an alternative approach. In a note last month, he observed that intraday trends tended to be stronger during times of low liquidity. That could be harnessed to improve the strategy.
“Measures of positioning and liquidity conditions are likely to become more popular in the trading signal to mitigate potential shortfalls,” Mukhopadhyay wrote.
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