Tail Risk in Momentum Strategy Returns

Momentum strategy returns are highly left skewed and leptokurtic. We explain this by the leverage dynamics of stocks in the momentum portfolio: under certain conditions past losers become highly levered, embedding a call option on the market. Based on this insight, we develop a hidden Markov model (HMM) that identifies such times when large losses are more likely using the convex relation between momentum and market returns. The estimated HMM predicts momentum strategy tail events better than alternative models both in- and out-of-sample. The dramatic momentum crashes result from this time-varying interaction with market returns, and not black-Swan like shocks.