The Hidden Cost of Volatility Drag

Trend following is a popular investment strategy that involves identifying trends in the market and buying or selling assets at the peak of those trends. However, one of the biggest challenges with trend following is managing volatility. In volatile markets, even the best-timed trades can result in significant losses.

That said, many commodity trading advisors have found success using trend following strategies to profitably trade in global futures markets. But has this strategy worked on stocks? We decided to put a long-only trend following strategy to the test by running it against a comprehensive database of U.S. stocks that had been adjusted for corporate actions.

Data Integrity

To verify the accuracy of our results, we used historical data spanning 22 years and applied realistic transaction cost estimates (slippage and commission) to ensure that any simulated trades were realistic. We also included 24,000+ securities in our database, covering all stocks that had been delisted at some point between 1983 and 2004. Our sample was slightly more than half of the total data points.

Corporate Actions

We applied a minimum stock price filter to avoid including penny stocks, which are often subject to rapid price swings. We also used a minimum daily liquidity filter to ensure that only liquid enough stocks could be traded at the time of each trade. This helped us to focus on companies with strong financials and high trading volumes.

Realistic Transaction Costs

To simulate realistic transaction costs, we back-adjusted stock prices for corporate actions such as dividends, splits, mergers, spin-offs, and rights issues. We also used slippage and commission estimates to account for the time value of money and other factors that can affect trade execution costs.

Coverage

Our database covered 24,000+ securities spanning 22 years. We performed our analysis over a period of 10 years, from 1983 to 1993, as this was the closest match to the testing period in our sample data. Our empirical results suggest that trend following on stocks does offer a positive mathematical expectancy.

What Does This Mean for Investors?

Our findings have significant implications for investors who are considering using trend following strategies in their portfolios. By identifying trends and buying or selling assets at the peak, trend followers can potentially capture gains from market movements. However, it's essential to note that volatility is a major risk factor in this strategy.

Entry & Exit

We chose the all-time highest close as our entry method. This meant buying stocks when their price was at an all-time high and selling them when it dropped below that level. We also used a stock that was at an all-time low as our exit point, meaning selling stocks when they reached their lowest value.

Entry Price

The entry price for each stock varied depending on the company's performance over time. For example, if we were looking at a company with a strong track record of dividend payments, we might have bought it at its lowest all-time low and sold it at its highest close. This strategy requires patience, as even small price movements can result in significant losses.

Survivorship Bias

One challenge to using trend following on stocks is survivorship bias. Poor performers may be removed from the sample before the analysis begins, leading to an overestimation of what past performance would have been like. To mitigate this risk, we applied a filter that excluded companies with delisted status for at least 5 years.

Mathematical Expectancy

Our empirical results suggest that trend following on stocks does offer a positive mathematical expectancy. This means that the weighted average of a probability distribution provides an estimate of what past performance would have been like. In our analysis, we used this concept to calculate the expected value of each stock's returns over time.

Systematic Nature

Trend followers often use systematic investing strategies, which involve defining clearly defined rules and testing them empirically. Our trend following strategy adheres to these principles, with clear rules for identifying trends and buying or selling assets at peak prices.

Long Volatility

One of the key benefits of trend following on stocks is its tendency to benefit from increasing volatility and persistent directional trends. This often involves using strategies like long-term positions or hedging techniques to manage risk in volatile markets.

Conclusion

In conclusion, our analysis suggests that trend following does work on stocks, at least in theory. However, it's essential to consider the risks involved and use these strategies judiciously. By understanding the underlying principles of trend following and applying them in a realistic way, investors can potentially capture gains from market movements.