Why stop-losses are inherent to managed futures strategies - protection from momentum crash risk

Research has well-documented the fact that momentum strategies are subjected to crash risk. In fact, crash risks is very hard to diversify relative to other major risk actors such as size or value. While there there is international diversification benefit for size and value, it is not found in momentum. Crash risk may cut across more markets. The momentum risk factor is subject to negative skew. There is more likelihood of a downside event than is the case with other risk premiums.

However, those researchers who have identified momentum crash risk have also found that it can be predicted. There are clear environments when crash risk is more likely, so investors can condition on these environments and cut the size of a crash event. Unfortunately, the events are rare and the warning time is limited. Additionally, there have been researchers who have found that simple stop-loss techniques can cut crash risk significantly and thus eliminate much of the negative skew. Risk management can mitigate the event risk seen with trading on momentum.

Managed futures  seems to be a hedge fund strategy where there is greater focus on risk management and the use of stops relative to other hedge fund strategies. You usually will not hear about stop-losses from a value investor or long/short equity managers, yet systematic traders will discuss stop-loss and risk management as a critical part of their value-added proposition.

There may be a good reason for why risk management is so front and center with managed futures relative to other hedge fund strategies. If crash risk is more likely with momentum based trading, a greater focus on risk management would be a natural means of reducing risk. The stop-loss is especially helpful if a strategy is more likely to have an unconditional negative skew.

Crash risk and organic risk management in managed futures are closely related although it has not been often discussed as being linked. If crash risk is correlated across markets because market reversals from past behavior are more macro-focused, then it will be harder to naturally diversify. There will be a need to use an external mechanism to reduce risk. The external means will be a stop-loss set to get out positions if there is a reversal in price. There is a reason for the strong risk focus in managed futures that is inherent with the behavior momentum strategies.

Managed futures firms inherently know that momentum crash risk is real and have thus adjusted their behavior. The did not need researchers to discover momentum risks, they knew it by trading everyday and realizing the special risk of following trends and momentum.