Trend-following - Living on long volatility and dying on short volatility

 

There are two key concepts that are fundamental to my view of trend-following. One, trend-following is a divergent trading strategy. Money is made when markets diverge from equilibrium; however, the time and size of divergence must match with the trends being identified. A strong or sharp short-term divergence may not for a long-term trend-follower Two, trend-following is long long volatility and short short volatility. Money is made when there is longer-term dispersion in markets and money is lost when there is a spike in short-term volatility which stops out longer-term positions. If there is no dispersion in prices, there are no strong trend profits. If there is a spike in short-term prices, positions are knocked-out. Trading with stops is a knock-out option strategy. 

Given the wide combination of divergences and volatility, there is a good reason to hold a portfolio of trend-followers who use different time frames, different strategies to access markets and manage risk, and different strategies that hold a diverse set of assets.

These two intersect when there is a condition of a longer-term divergence. A change in market fundamentals from the existing price range that is not immediate seen by investors will lead to profitable trends.  We saw this environment during the GFC, the pandemic and aftermath. 2022 was a great year as the market adjusted to higher inflation. Unfortunately, these ripe conditions do not exist in 2023. The SG Trend index shows one of the worst declines since inception which reversed half of the 2022 gains.

In this 2023 case, we have had a market divergence, a bank crisis, that is turning into a banking crisis. First, there has been an unexpected market shock which has led to a spike in short-term volatility that has caught the market wrong-footed relative to existing trends. The result has been swift and strong. Strong losses in bond trading and choppy market behavior in equity indices. The divergence has been arrested by government policies to contain the shock. The longer trends may prove profitable but the short-term has been a period of position adjustment surrounded by losses. These losses will be offset if the market divergence continues. Any continuation will be a function of government policies; nevertheless, the restriction on policy choices from inflation may mean that longer-term trend following may still be profitable in 2023.