The Hidden Cost of Volatility Drag: Unpacking the Dynamics of Trend Following

That said, trend following has been a popular trading philosophy for many years, attracting investors seeking consistent returns with relatively low risk. However, surprisingly little has been written about its origins and history, largely due to the scarcity of available information prior to the early 20th century.

To understand the nature of trend following, it's essential to delve into its dual natures. At a level that is at one level a phenomenon of the human psyche, an expression of the Keynesian "animal spirits" that percolate from the deepest levels of our being. This type of trend following is spontaneous, inductive, adaptive and evolutionary – a burst of conformity to innovations in our immediate environment.

At this level, the masses have always been trend followers, not only in financial matters but also in terms of music, art, clothing and basic world-views. However, it's essential to distinguish between these two levels of trend following. The other level of trend following is something entirely else – a meta-level that sits above the tableau of material and psychological cause and effect.

This meta-level allows participants to observe the behavior of the markets as a whole and design intelligent, premeditated responses to market action. This is the level from which we as traders should operate. To be clear, this level can become complex, but its essential elements can be simply stated: initiating positions based on the perceived direction of the trend (1), holding positions based on that direction (2), and liquidating positions based on the perceived direction (3). There's also a fourth aspect to consider – doing all these things systematically, on the basis of logical relationships or mathematical formulations.

Generally speaking, trend following systems look for their implementation only at the movement of prices. The basic perception is that if a market's price is going to make an exceptional move in one direction or another, it must first make a moderate move in that direction, leading to the conclusion that if an initiation can be made at that moderate level, the remaining portion of the trend can be followed for a significant period of time thereafter and liquidated at a profit.

The scenario is not always expected to be true, but if it's true often enough, and to a significant degree enough, then it may lead to profitable trading in the long run. This concept has been applied in various markets throughout history, from ancient times to modern-day finance.

Stig Ostgaard: A Pioneer in Trend Following

While we can't associate trend following with human nature directly, we do know that the first trend followers were not necessarily traders. However, as traders and investors, they likely understood the concept of trend following intuitively. One notable figure who embodied this idea was Stig Ostgaard.

Stig Ostgaard is a pioneer in the field of trend following, having developed a robust methodology for identifying and exploiting trends in various markets. His approach has been widely adopted by traders and investors seeking to capitalize on market movements.

The Origins of Trend Following: A Historical Perspective

Trend following has its roots in 19th-century finance, where traders began to analyze price movements using technical indicators. However, the concept of trend following as a trading philosophy did not gain widespread acceptance until the early 20th century.

It's worth noting that by the 1950s, many trend following methodologies were already in common use. This suggests that trend following had been around for some time before being articulated or fully defined.

A Tale of Two Levels: Trend Following at the Macro and Micro Levels

At the macro level, trend following is often associated with market averages and indices. However, this perspective overlooks the importance of individual stocks and traders in shaping market movements.

In contrast, micro-level trend following involves observing the behavior of specific stocks or traders as a whole. This approach can provide valuable insights into market dynamics, but it also requires a high degree of expertise and analysis.

What Does Trend Following Mean for Portfolios?

Trend following has implications for portfolio management, particularly in terms of asset allocation and risk management. By identifying and exploiting trends in various markets, trend followers can create diversified portfolios that maximize returns while minimizing risk.

However, trend followers must also be aware of the risks associated with trend following, such as over-trading or under-trading. It's essential to develop a systematic approach to trend following that balances risk and potential returns.

Practical Implementation: Trend Following in Real-World Markets

Implementing trend following strategies requires discipline, patience, and persistence. Traders must be willing to adapt their approaches based on changing market conditions and new data.

Some key considerations when implementing trend following strategies include:

Timing: Trading at the right time is critical in trend following. Traders must be able to recognize opportunities and adjust their positions accordingly. Position sizing: Managing risk is essential in trend following. Traders must set clear position limits and adjust them as needed based on market conditions. Risk management: Trend followers should also develop a solid risk management framework that balances potential returns with risk tolerance.

A 10-Year Backtest Reveals...

A well-known 10-year backtest of the popular trend following strategy, known as the "Fibonacci retracement levels," reveals some interesting insights into the behavior of this strategy. The test shows that while the strategy is not without its flaws, it can be a valuable tool for investors seeking to exploit market trends.

What the Data Actually Shows

The data on trend following strategies suggests that they are often over-traded or under-traded. This highlights the importance of developing a systematic approach to trend following that balances risk and potential returns.

Some key findings from the data include:

Trend followers tend to trade frequently, but not necessarily at the optimal frequency. The "Fibonacci retracement levels" strategy is particularly prone to over-trading. Trend followers who use more sophisticated risk management techniques are less likely to experience losses.

Three Scenarios to Consider

1. Conservative Approach: In this scenario, trend followers adopt a conservative approach, focusing on long-term investments and avoiding high-risk trades. This can be an effective strategy for investors seeking to minimize risk while maximizing returns. 2. Moderate Approach: In this scenario, trend followers adopt a moderate approach, balancing risk tolerance with potential returns. This can be an effective strategy for investors seeking to maximize returns without excessive risk. 3. Aggressive Approach: In this scenario, trend followers adopt an aggressive approach, focusing on high-risk trades and taking larger positions. However, this approach requires significant expertise and may not be suitable for all investors.

The choice of approach will depend on the individual investor's risk tolerance, investment goals, and market conditions. By carefully considering these factors, trend followers can develop a systematic approach that balances risk and potential returns.