Conditional momentum based on the basis (carry) - It works

Trend-following and momentum strategy performance can be improved upon through combining it with carry strategies. We have described blending trend and carry at a high level as combining convex (trend/momentum) strategies with concave (carry) strategies. See Blending trend-following and carry through simple diagrams. This combination of momentum strategies (a long/short trend relative or cross-sectional time series approach) with a carry strategy, which has a better stand-alone return, can provide a better overall return pay-off.

This combination can also be integrated into a single model by making the momentum trades conditional on carry. With respect to futures trading, this combination will make the momentum trades conditional on the basis or difference between the nearby and next to nearby futures contract. The basis is positive (negative) if the market is in backwardation (contango). The conditional approach will cut short trades (negative momentum) when the basis is positive (backwardation) and cut long trades (positive momentum) when the basis is negative (contango) This a simple combined conditional model will generate a significantly improved Sharpe ratio over the unconditional approach that only uses momentum. 

The research on this comparison of strategies, which looks across a large set of markets and asset classes, is compelling. See "Carry and time-series momentum: a match made in heaven" by Molyboga, Qian, and He. Using their extensive data set, the researchers find a meaningful jump in Sharpe ratio performance. Interestingly, the large gains in the conditional Sharpe ratio comes during recessions. This is also likely the time when markets switch from backwardation to contango.

There are simple ways to improve on trend-following and momentum strategies that will generate extra return when needed during "bad times" and provide added overall return per unit of risk. This combination will cut any problems with momentum crashes and smooth returns. This strategy mix can be done efficiently in a single modeling approach.