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Cross-Sectional Momentum: Buying Last Month's Winners

Cross-sectional momentum compares currencies against each other. It buys those that have performed best recently, and sells those that have performed worst, expecting the ranking to persist for a while. The procedure is simple. Choose a group of major currencies, measure each one's performance against the dollar or against a basket over a lookback period, such as the last one to twelve months, rank them, and take long positions in the top group and short positions in the bottom group. Hold for a period, then rebalance.

Academic studies have documented momentum in currencies over horizons of several months, though the effect varies across periods and has weakened at times. Explanations include slow adjustment to information and the behavior of central banks, which move policy gradually.

The strategy produces periodic losses, particularly at turning points, when trends reverse. It also requires patience, with holding periods of weeks or months.

Practical considerations include transaction costs, which are small relative to the holding period, and swap, which can offset returns if you are long low-yielding currencies and short high-yielding ones.

Risk management is vital. Equal-risk weighting by volatility avoids dominance by the most volatile currencies. Position limits prevent excessive concentration.

You can test a basic version in a spreadsheet using monthly closing prices, which makes it accessible without special software.

Practical step: rank eight major currencies by their three-month performance against the dollar, and see which pairs the ranking would suggest.

Monthly closes in a spreadsheet really is enough to test this. No special software, just rank and record the next month's result. It's a good weekend project. Take eight or nine major currencies against the dollar, get the month end closes for a few years, calculate the three month change for each, rank them, and then note what the top two and bottom two did the following month. After a couple of hours you'll have a rough idea of whether the effect shows up in recent years or not. Don't expect smooth results. Even when it works, there are long stretches where it doesn't, especially around big turning points.

Watch the swap side. Momentum can put you long a low yielder and short a high yielder, and paying carry every night on a trade held for weeks adds up. That's a real conflict, because carry and momentum sometimes point in opposite directions. If the strongest currency recently is also a low yielder, the momentum long costs you swap. Some people combine the two signals, only taking momentum trades where the carry is neutral or positive. That reduces the number of trades but removes the steady drain. Either way, include the swap in your test results. Ignoring it can make a momentum strategy look a lot better than it would have been.