Should we catch the falling knife in Hong Kong

Key points:

• A short-term gauge of price momentum shows a sharp contraction in Hong Kong stocks
• The 15-day rate of change for the Hang Seng Index declined by more than 21%
• Similar momentum signals show favorable near term results

What happens when short-term price momentum accelerates to the downside

Let's conduct a study to assess the outlook for the Hang Seng Index when the 15-day rate of change declines by more than 20%. I will use a reset above zero on the rate of change to screen out duplicates.

The current downside momentum in the Hang Seng Index was last seen in October 2008.

Similar episodes of negative momentum suggest a near term bounce

This signal has triggered 25 other times over the past 51 years. After the others, the Hang Seng Index shows solid returns, win rates, and risk/reward profiles in the 1 & 2 week time frames. The 1-week window looks pretty compelling, especially the more recent signals, which shows 12 out of 14 winners since 1982. Momentum signals like this are tricky because it's difficult to distinguish between a one-and-done versus the first in a series like the Asian contagion.

Don't catch the falling knife

Let's see if we would be better off if we waited for a burst of positive momentum before buying the dip. The goal is to find a better risk/reward profile for a mean reversion trade. After running an optimization process, the test identified a 5-day rate of change of >= 14% within 25 days of the 15-day rate of change cross below -20%. I included the count condition because I wanted to ensure that the thrust signal was associated with the negative momentum in our original study. The optimal days-in-trade exit signal returned 25 sessions. The 25-day exit shows 9 winning trades with 2 losses for an 82% win rate.

The outlook table shows that once the momentum signal triggers, one would be better suited by initiating a trade after some backing and filling or in multiple tranches.

What the research tells us...

When the Hang Seng Index shows a massive downward shift in price momentum, the adverse price action can provide a potential near-term mean reversion edge. Similar signals to what we're seeing now have preceded solid returns, win rates, and risk/reward profiles in the near term, especially the 1-week time frame. If we wait for price momentum to turn up, we can improve the outlook for a longer-duration trade once the dust settles.