[MUSIC] Learning Outcomes. After watching this video you'll be able to understand the momentum strategy in detail, and implement the momentum strategy. Momentum strategy. The momentum strategy is very simple. All you have to do is, long the winners portfolio and short the losers portfolio. I know, I haven't explained what a winners portfolio and losers portfolio are. We will get there shortly. Let us now get in to the details of the strategy. As I have mentioned previously, we will be considering the intermediate term momentum of selling stocks. We will make use of the back periods of three months, six months, nine months, and 12 months. In addition, we will also consider holding periods that vary from one to four quarters. Taking all the possible combinations of these, will give us a total of 16 strategies. Let me elaborate on this. Three month look back period, and three month holding period. Three month look back period, and six month holding period. Three month look back period and nine month holding period. Three month look back period, and 12 month holding period. Then we start with six month look back period, and three month holding period, and so on. Like this if you do you get a total of 16 strategies. Now, you can analyze all these strategies. But for the purpose of this course, we will just be looking at the 12 month look back period, and three month holding period strategy. Let us look at the various steps in the strategy. The first step data preparation. Pick all the stocks which have the stock press data available for the last 12 months. Why are we taking this 12 months? 12 months because it is our look back period. In case your look back period is six months, you can take all the stocks which have stock press data available for the last six months. If any of the stocks have one or more days with no trade, then we screen all these stocks. This helps us to identify relatively liquid stocks and get rid of iliquid stocks. You will now calculate the daily returns from these stock prices. You'll take these daily returns, compound them to calculate the monthly returns. Your data is now ready for further analysis. You have the stocks, you have the monthly returns for the look back period of 12 months. Now we go on to the second step. The second step is calculation of intermediate term momentum. We make a slight modification to the way we calculate momentum. We calculate the cumulative 12 month returns after removing the last month returns. Now why are we skipping a month? By skipping a month, we award the short term momentum effects documented by. If you remember, we have studied these effects in the last lesson. Now the calculation is similar to what we did previously. Just that, we do not consider the returns of the 12th month. The slide shows how the calculation changes. We do not consider the 15% net returns in the month of December, so we have only 11 months net returns now. From these, we calculate the gross returns by adding one to the net returns. Now, we will multiply this eleven month returns and subtract one from the product. We get the new value of momentum, which is equal to 31.71%. Two, distinguish this newly calculated momentum from the momentum previously calculated. We will call this the modified intermediate term momentum. Now, this brings us to our third step. The third step is creating winner and loser portfolios. So, what you will do is you will rank the stocks in ascending order based on their modified intermediate momentum. That is, cumulative past 12 month returns after removing the last month returns, okay? Now, the stocks that you have, you will divide these stocks into designs. Based on the designs you create an equally weighted portfolios. The lower returns design portfolio is called the loser portfolio, and the higher returns design portfolio is called the winner portfolio. According to the momentum anomaly, the winner portfolio should outperform the loser portfolio. So, our strategy will involve, longing the winner portfolio and shorting the loser portfolio. Now we go to this step four. Now that we have created the winning and losing portfolio, how do you trade them? This brings us to the next step in the strategy which is trading. As I have mentioned previously you long the winner portfolio, and short the loser portfolio. That is you're longing stocks with the strongest momentum, and shorting stocks with the lowest momentum. The portfolio so created is called a pure momentum portfolio. This is one way to trade. There is one more way to trade. The results show that returns from winners portfolio are more, compared to the returns from losers portfolio. So you can take advantage of this. This means you can long the stocks with strong momentum, without shorting market index or the low momentum stocks. But as we have seen previously, this strategy is slightly risky because it is exposed to market risks. So these are the two ways in which you can trade these portfolios. This brings us to the last stage of the strategy, the fifth step holding period. The research by Jagdesh and Titman shows that abnormal returns generated in the first year, dissipate in the following two years. That is, for how to put this in simple words, if you study returns for three years after the creation of a portfolio, in the first year the portfolio generates positive returns. But the returns keep decreasing in the subsequent two years. So it is not advisable to have a very long holding period. This is the reason why we limit our holding period to three months. But you can experiment with various lengths between 3 and 12 months. And you can pick a holding period which suits your requirements. Now, let us quickly summarize what we have done so far. We saw what stocks to consider. We also saw how to create the winners and the losers portfolio. Also, we have seen what holding period to use. In the next video, we will see how well our strategy fairs, and discuss the results that we get from using this momentum strategy in the Indian market. [MUSIC]