“Trend following has had positive returns over a 20 year period because 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 of doing so. These models create an expected return profile similar to being long options…” — Michael Rulle
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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.
Trend following achieves positive returns because long-term (1 to 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 long-term trend that appears in any market.
The cost of capturing trends 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.
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.
Understanding the Long Option Analogy
Rulle’s framing of trend following as producing a return profile similar to being long options is one of the most useful available analogies for explaining the approach to practitioners with options trading backgrounds. The comparison is precise rather than approximate.
A long options position has defined maximum loss (the premium paid), unlimited potential gain, and a payoff profile that is convex: small adverse moves cost little, large adverse moves cost slightly more (but not proportionally more), and large favorable moves produce returns that accelerate with the magnitude of the move. The long option holder loses the premium on options that expire worthless and captures large gains on options that move deep in the money.
Trend following has the same profile. Each trade risks a defined small percentage of equity (analogous to the option premium). Most trades are small losers or small winners that expire without capturing a large trend (analogous to options expiring worthless or with small gains). Occasionally, a trade catches a large sustained trend and produces returns that are large multiples of the initial risk (analogous to an option moving deep in the money). The portfolio’s positive expected value comes from the occasional large winners, not from the frequent small winners.
The convexity is the important feature. During normal, ranging, non-trending market conditions, trend following produces small losses and small gains that roughly cancel. During crisis periods, when large sustained directional moves occur across multiple markets simultaneously, trend following captures returns that are large relative to the losses incurred during the quiet periods. This is why trend following has historically produced its best returns during equity market crises: crises produce exactly the large sustained directional moves in bonds, currencies, and commodities that the long option profile is positioned to capture.
The connection between Graham Capital and John W. Henry’s firm through Tropin is another instance of the small world that systematic trend following represents. The practitioners who built the industry’s largest and most respected operations trained under each other, competed at the same firms, and developed approaches that are similar enough to be highly correlated in their returns while distinct enough to have slightly different market exposures and time horizons. The institutional genealogy of the industry traces back to a handful of practitioners in the 1970s and 1980s.
Frequently Asked Questions
Why does trend following produce a return profile similar to being long options?
Because both have convex payoff profiles with defined limited losses and potentially large gains. A trend following position risks a defined percentage of equity on each trade (analogous to the option premium) and produces small losses on trades that do not develop into sustained trends, while capturing large multiples of the initial risk on trades that catch major trends. The positive expected value comes from the occasional large winners, exactly as with a long options portfolio.
What is the cost of trend following and how is it managed?
The cost is the losses on trades that initially appear to be trends but reverse before developing into sustained moves. Trend following manages this cost by cutting losses quickly (exiting when the initial stop fires) and letting profits run (not exiting winning positions at arbitrary profit targets). This is the cut losses/let profits run principle stated in return profile terms: keep the cost of false trend signals small, and capture the full value of real trend signals.
Who is Michael Rulle and what is his connection to the systematic trading world?
Michael Rulle is President of Graham Capital Management, one of the major systematic trading operations in the industry. Graham Capital was founded by Ken Tropin, who previously served as President of John W. Henry’s firm. This direct lineage from JWH to Graham Capital is one of many examples of the tight institutional genealogy of the systematic trading industry, where the major practitioners trained under each other and built independent operations using similar foundational approaches.
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