Positive Trend Following Performance Depends on Persistent Trends, Not High Volatility

Great trends can exist despite low and declining volatility. People seem to have gotten the idea that trend following performance has been poor over the past couple of years because of low market volatility. Not true. Trend reversals and false breakouts are the culprits, not low volatility.

I don’t root for volatility. I root for trends. Sometimes markets trend despite low and declining volatility. They can exist with high and increasing volatility too, but positive trend following performance does not need high volatility.

Here are a few examples of what I mean…

Chart 1 – Soybean Oil

From 2012 to mid 2015, Soybean Oil prices and it’s volatility, as measured by 60-day Average True Range, both fall ~50%. A simple trend following indicator, the 200-day price channel (blue lines), capture this large multi-year trend despite low volatility. Trend followers need trends to profit. They don’t need the VIX at 30, interest rates at 5% or some other half-baked marketing spin to make money. They need trends. Plain and simple.

Chart 2 – Hong Kong Stock Market

If volatility is so good, explain the negative performance a simple trend following strategy experiences in Hong Kong stocks during 2015. Volatility spikes ~100%. Volatility is a good thing right, so what’s the problem? The problem is that the uptrend reverses significantly and the trend following system that’s been long since 2013 loses money. I repeat: volatility isn’t always a good thing.

Chart 3 – Platinum

There may be times where volatility increases and decreases while the trend stays in tact. Such is the case in Platinum in 2007-08. In the green box, prices rally ~25% while volatility falls ~40%. In the red box, prices rally another ~40% and volatility explodes 300% higher. Just because volatility declines during the green box time period doesn’t mean trend followers cannot make money.

Trend traders need persistent trends more than they need high volatility.

Over the past couple of years, trends are very scarce. In 2015, we see major reversals in the smooth currency and bond trends from 2014. In 2016, the world prepares for Brexit, the US election and changes to central bank policies. This creates massive complacency and, as a result, no trends. 2017 is experiencing the hangover from 2016. People are still in “wait and see” mode. When this occurs, trends don’t stick; we just get this wishy washy back and forth movement.

As your fearless leader, during these extended periods of directionless markets, I try to keep a cool head. Most of the time I do, but sometimes I want to put my foot through a wall and break my phone into a million pieces. Trend Following, like any strategy, is hard to execute during a long losing streak. You feel cursed; like no matter what you do, you just can’t get on the right side of the markets. You have a hard time imagining what the good times feel like. Sadly, the losing streaks, I believe, are vital to ensuring the long-term viability of trend following.

No strategy can work all the time. It must buck people off the horse and make them quit or change their style. The winners stay true and just accept losing as part of the deal no matter how gut-wrenching it feels. I have a love-hate relationship with this notion. I love that to win, you have to keep it simple and stick to your discipline. I hate it because you don’t always win.

Disclosure

Past performance is not necessarily indicative of future results. Alternative investments, including those offered by Melissinos Trading, are speculative, involve substantial risk, and are not suitable for all investors.

This communication is for information purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy any financial product, an official confirmation of any transaction, or as an official statement of Melissinos Trading LLC. All information is subject to change without notice.

The charts show examples of trends. Inclusion of a chart as a trend example does not imply any kind of recommendation to buy, sell, hold or stay out.

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