A Rational Foundation for Trend-Chasing and Contrarian Trades with Implications for Momentum Anomalies

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Abstract

Trend-chasing and Contrarian are well-documented empirical trading patterns that the literature generally attributes to behavioral biases. In contrast, we argue that both are rational portfolio rebalancing strategies in a dynamic asset allocation framework. Analyzing the interactions between strategies implemented in stocks and bonds, we find that a key parameter is the investor's level of relative-risk-aversion versus the market price of risk. Our mapping of preferences to trades fits remarkably well recent empirical findings of time-series momentum and reversal. Specifically, speculators trade like Trend-chasers throughout the momentum phase closing positions once the trend reverses, while hedgers trade like Contrarians. These trades seem to explain time-series momentum.

Original languageEnglish
Article number1350003
JournalQuarterly Journal of Finance
Volume3
Issue number1
DOIs
StatePublished - 1 Mar 2013

Keywords

  • Contrarian
  • Trend-chasing
  • momentum
  • rational
  • reversal

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics
  • Strategy and Management

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