Trend-following and equity markets - control the costs

 

There is money to be made trading long-only trends in equities but like all trading it is not easy and driven significantly by cost assumptions. In fact, it is the cost control that may be the most important alpha producer. Take what may seem like a good model without transaction costs and then add realistic slippage and trading costs and you will see significant alpha deterioration. Redo the analysis but then add a set of rules that account for turnover and costs to reduce the number of trades, and you can add back alpha. Of course, you will never get back to the original theoretical performance without any trading costs, but the number may still look attractive. There is no free lunch and there is no hidden lunch. Perhaps the easiest place to find alpha is through optimizing for costs. 

While cost analysis was not the main goal of the paper, "Does Trend Following Still Work on Stocks" it may be the key takeaway. The model is simply based on looking for new highs for stocks with an ATR stop exit strategy. There are no special features, but it does work until we add reasonable cost assumptions. Nevertheless, simple rule changes can get the strategy back on the right track through minimizing turn-over. Along with entry and exit signals, place turnover constraints into the model.