[MUSIC] Learning Outcomes, after completing this video you'll be able to understand the basics of momentum. Hi, my name is Sai Harsha, I'm working as an analyst in the Center for Analytical Finance at Indian School of Business. I'll be talking you through the momentum strategy. The lesson plan is very straight forward. First, we'll be discussing the basics of momentum followed by the actual strategy. Then we will discuss the results of deep momentum strategy in the context of the Indian market. This will be followed by the latest research in the area of momentum. Let us first understand the meaning of momentum. You might have studied in your physics that momentum is the product of mass and velocity, the momentum we are going to study today is different. So, what is this momentum? In the finance parlance, momentum refers to the tendency of rising stock prices to rise up further and falling stock prices to fall further. In simple words, if you have two portfolios of stocks, one consisting of stocks with strong past performance, and the other consisting of stocks with weak past performance, then momentum says that the stocks with strong past performance will outperform the stocks with the weak past performance. Now, you'll ask me, so what? Let me tell you why this is important. Let us go back to our efficient market hypothesis. According to efficient market hypothesis, at any point in time security prices are said to reflect all available information. This means, you cannot predict the future stock price. But, momentum shows that rising stock prices rise further up. That is, it is predicting the direction of stock price and this is against your efficient market hypothesis. Now, when a security or a group of securities, perform contrary to the notion of efficient markets, we call it an anomaly. Momentum is a market anomaly. Momentum is one of the most investigated effects in academia. Hundreds of papers have been written on this topic. A lot of studies have shown that the momentum effect works in the US markets, stock markets of other developed countries, and also in the emerging markets. This effect works in large cap stocks, as well as small cap stocks. Our strategy is based on this anomaly. Now that we have understood the meaning of momentum, let us learn how to measure it. So the next question we are going to answer is, how do you measure the momentum of a stock? Momentum is the total return of a stock including the dividends of the stock over the last n months. This period of n months is called the lookback period. You are here, this data changes future and this data changes past. You are calculating the return over the previous end period. So we call this the lookback period. The lookback period is very important, and we will discuss the importance of this shortly. Now, before we proceed any further, I would like to clarify one more thing. We have an indicator by name, momentum indicator, in technical analysis also. To distinguish this momentum from that of technical analysis, we will call this momentum generic momentum, or simply momentum. If I have to refer to the other momentum indicator of technical analysis, I will clearly mention it to you. Now, let us go back to the lookback period. The lookback period can be anything from one week to five years. We have research using a lookback period of one week, and we also have research using a lookback period of five years. So that means you can have a lookback period anywhere between one week and five years. First, now let us calculate the momentum of a particular stock for a particular lookback period. For the purpose of this calculation let us assume the lookback period to be 12 months. Later on, I will tell you what will happen if you consider lookback periods of different durations, and I will also tell you the lookback period you have to use while clearing this momentum strategy. Now, let me take you through an example to make this clear. You want to calculate the momentum of Amazon stock over a lookback period of 12 months. This means that you have to calculate the cumulative return of Amazon stock over the last 12 months. In order to do so, first, we calculate the net returns for each month. And convert these net returns into gross returns by adding 1. Let's take a small example. If Amazon's net returns for the month of January are 10%, okay, in order to get the gross returns, what we have to do is we have to add 1 to this. That is, first take this 10%, convert it into decimal, 10% converted to decimal is 0.1. Now, to this 0.1 you add 1, and you get the gross returns as 1.1. Now, had the net returns been -10%, you'll first convert it to decimal, which gives you -0.1, to this you add 1. Then the gross returns will be 0.9. You can see the net returns of Amazon for the last one month on this slide. In the first column, we have monthly net returns. Now, if you observed we have negative returns for the months of February, June, August and October. This means that the stock has performed badly in these months. Now, in the second column we have the gross returns. We got these gross returns by adding 1 to the net returns. In order to calculate the momentum, we multiply the gross returns of all the 12 months and subtract 1 from them. This gives us the momentum over a lookback period of 12 months. You can see all the calculations on these slides. Now after doing all the calculations, the momentum for Amazon is 51.47%. Now, in the next video we'll understand the lookback period in greater detail. [MUSIC]
