Downside Volatility Determines Trend-Following Profits

The success of trend-following strategies is more dependent on the volatility of the underlying asset following a buy or sell signal than the rules used for determining when signals are issued.

Trend-following strategies are designed to give “buy” signals when prices are rising and “sell” signals when prices are falling. The success of such strategies is significantly dependent on the volatility of the underlying asset following the issuance of a signal to buy or sell, according to a recent study. This has a bigger impact than the rules used for determining when signals are issued.

An investor following a trend signal would buy an investment if its price crossed above a certain marker such as a moving average. (A moving average plots the rolling average price on, say, each trading day in the form of a continuous line.) Once the investment’s price falls back below the trendline, a sell signal is generated. The sell signal prompts the investor to either allocate to a risk-free asset (e.g., cash) or short the investment.

The profits from buying the investment will be the same as a buy-and-hold strategy over the holding period following the buy signal. The possibility of realizing higher excess returns from that point on will be dependent on the magnitude of the investment’s price decline, when the investment rebounds and the incurred transaction costs.

Associate finance professor Adrian Zoicas-Ienciu gave the following example of the potential outcome following a sell signal: “If the price continues to decline while the investor holds the risk-free asset or shorts the risky asset, the sell signal is correct. If the price rebounds, the investor loses the opportunity of this positive return, records a negative trading cost return and an actual negative return if she shorts during the sell exposure.”

This is why the magnitude of the decline following the sell signal determines the profitability of the trend-following strategy. “The more intense and/or longer the downtrend, the more superb the trend-following excess returns regardless of its actual forecasting ability,” explained Zoicas-Ienciu.

Such excess returns have historically been episodic. Trend-following worked well during market crashes over the period of 1927 through 2016. Its rate of success, however, was either very high or very low over the 64 subperiods measured. The study’s author attributed this as implying that the success of trend-following is primarily dependent on how prices changed over the periods of time measured.

Source: “What Drives Trend-Following Profits?,” Adrian Zoicas-Ienciu, SSRN, April 2017.