Many trend following traders always seem to be explaining their investment style to “skeptics”. One way to think about the concept of trend following is put forward by Michael Rulle. Michael is President of Graham Capital. Ken Tropin founded Graham Capital. Where was he before that? Tropin is the former President of John W. Henry’s firm. Small world!
Rulle offers:
Trend following achieves positive returns because long-term (1-12 months) trends occur in virtually all markets some of the time. Trend followers create quantitative models to capture these long-term trends while limiting the cost. The strategy will generally capture almost every ex-post long-term trend that appears in any market. The cost of such capturing occurs when trends initially appear but end up reversing and the trend follower loses money. The way trend followers manage this trade-off between capturing a real trend and having a loss related to a false trend is to “cut losses” and to “let profits run.” This approach to trading is, in fact, similar to being long options. Because the “stop loss” creates a limited downside, staying invested in a real trend creates the potential for a very large upside. In an article titled The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers, the authors, William Fung and David A. Hsieh, demonstrate that trend following returns are highly correlated with being long call options and put options (i.e., straddles) on markets.
Breaking this down, what does it mean for the average trader?
The stop loss in trend following is very much like the option premium you pay to buy a call or a put. You have limited downside and unlimited upside. Most investment strategies don’t have a plan for losses. There are no stops. There are no exits.
Don’t let the “academic writing” of Rulle or William Fung or David A. Hsieh confuse the big picture point. It’s a fancy way of describing the idea of cutting your losses short and letting your profits run. Sure, it sounds simple, but think about how many people don’t do it.
More from Graham Capital
Trend following: Performance, Risk and Correlation Characteristics
Why the Options Analogy Is Precise
The Fung and Hsieh research finding that trend following returns are highly correlated with being long straddles is not incidental. A long straddle, buying both a call and a put, profits when the underlying moves significantly in either direction and loses the premium when the underlying stays flat. Trend following has exactly this payoff profile. It profits when markets trend significantly in either direction, up or down, and loses small amounts during choppy, directionless periods when entries fail to develop into trends. The premium paid in an options straddle corresponds to the cumulative small losses trend following incurs during non-trending periods.
The analogy clarifies why trend following’s return distribution looks the way it does. Straddle buyers experience frequent small losses, the premium, and infrequent large gains when the underlying moves sharply. Trend followers experience frequent small losses, the failed breakouts, and infrequent large gains when a sustained trend develops and is held through its full extent. Both strategies have positively skewed return distributions: most individual outcomes are small losses, the occasional large win produces the long-run positive expectancy.
Rulle’s framing also explains why trend following has natural diversification properties in a traditional portfolio. Long option positions tend to perform well in the same environments that equity portfolios perform poorly: periods of high volatility and sharp directional movement. Trend following performs well for exactly the same structural reason. The crisis events that produce severe equity losses also produce large, sustained trends in other markets, currencies, bonds, commodities, and sometimes the equity market itself on the short side. A portfolio that includes both long-only equities and a systematic trend following allocation is combining two positions with opposite performance characteristics in crisis environments.
The bottom line that Rulle arrives at, that it is a fancy way of describing cut your losses short and let your profits run, is correct. The academic framing of straddle equivalence adds analytical precision and explains the return distribution in terms that portfolio theorists can model. But the trading principle is unchanged from what practitioners have known for decades. Limited downside, unlimited upside, achieved by consistently following the two rules that almost nobody consistently follows.
Frequently Asked Questions
How is trend following similar to being long options?
Both have a defined maximum loss, the option premium for a long option position and the stop loss for a trend following trade, and an unlimited potential gain if the underlying moves strongly in the right direction. Both produce frequent small losses and infrequent large gains, creating a positively skewed return distribution. Fung and Hsieh demonstrated this correlation statistically, showing that trend following returns are highly correlated with long straddle positions across markets.
What is the cost of trend following and what produces it?
The cost consists of the small losses incurred when market breakouts fail to develop into sustained trends. A trend following system enters on a price breakout and exits at a stop if the trend reverses. When many breakouts fail, the system accumulates small losses. These losses are the equivalent of options premiums: the price paid for the opportunity to capture large gains when a sustained trend develops.
Why does trend following provide natural portfolio diversification?
Because its return profile is similar to being long straddles, which tend to perform well during high-volatility, crisis environments when traditional long-only equity portfolios suffer most. The same market conditions that produce equity market losses, sharp directional moves driven by fear and uncertainty, also produce sustained trends in other markets that systematic trend following captures. This structural opposition makes trend following one of the few strategies with genuinely negative correlation to equities during crises.
Who is Ken Tropin and what is his connection to the trend following world?
Ken Tropin is the founder of Graham Capital Management, one of the larger systematic trend following firms. Before founding Graham Capital, he was President of JWM Associates, the firm run by John W. Henry, one of the great trend followers of all time. The overlap in personnel across the major systematic trading firms reflects the relatively small community that developed systematic trend following into an institutional investment approach.
Trend Following Systems
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