Cross-Sectional Momentum in the Commodity Market

Momentum trading is often divided into 2 categories: time-series momentum and cross-sectional momentum. Time-series based trading strategies generate trading signals based on the asset’s past returns. A typical time-series trading strategy usually involves buying assets with positive trend signals and selling those with negative trend signals. In contrast, cross-sectional trading strategies generate trading signals based on the relative performance of assets. A typical cross-sectional trading strategy involves buying assets with the highest-ranked trend signals and selling those with the lowest-ranked trend signals. So basically this is a relative value strategy.

Reference [1] examined trend trading in the commodity market from the cross-sectional momentum perspective. The authors conducted a study on a portfolio of 35 commodity futures. They pointed out,

In this paper, we provide a trend factor that exploits the short-, intermediate-, and long-run moving averages of settlement prices in commodity futures markets. It outperforms the momentum benchmark significantly. During our sample period January 2004–December 2020, the trend factor generates statistically and economically large returns while the average return of the momentum factor is insignificant. The trend factor also has less downside risk than the momentum factor. The returns of the trend factor cannot be explained by existing multifactor models. The trend factor also generates a significant and positive risk premium.

In short, cross-sectional momentum exists in the commodity market and it is possible to construct a profitable trend trading strategy. The authors went on to identify the underlying risk/PnL driver of the thus developed trading strategy,

…the trend factor is correlated with funding liquidity measured by the TED spread. Overall, our results indicate that past prices contain important information on the expected returns in commodity futures markets.

In other words, the underlying PnL driver is the TED spread which represents the funding liquidity.

References

[1] Han, Yufeng and Kong, Lingfei, A Trend Factor in Commodity Futures Markets: Any Economic Gains From Using Information Over Investment Horizons? (October 31, 2021). Available at SSRN: https://ssrn.com/abstract=3953845

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