Trend Following is Dead, Long Live Trend Following

2020 was an awesome year for trend following traders. They made money when the market went down in March and made money when the markets rebounded for the rest of the year. 2021 on the other hand seems like a year (and one that is not even half done) and I am pretty sure most clients have either quit or close to quitting the strategy that seems to see no end to whips. 

I used to be a systematic trend follower (and a discretionary trend follower earlier) for a while before I realized that this game was not for me. The reason is not that I did not have a good system to begin with – in the long run every trend following systems generates returns that are slightly lower than the underlying on which it trades but with a much reduced risk (risk being measured through draw-downs).

If markets have a risk of 50% draw-down, the idea here is to try and limit the damage to say 25% so as to allow 2 times leverage (or 3 if you are iron hearted) and which allows for the absolute outperformance of the underlying. For example – assume you have a system that will generate 1000 points on Nifty vs say 1200 points Nifty would have generated for a buy and hold investor. But the buy and hold investor would also go through a pain of a 50% drop in value at some point of time. 

If you are a Buy and Hold investor and try to leverage on Nifty at just 2 times, once you hit the 50% drawdown (in reality it will be even earlier), your capital is fully destroyed. But if your system which generates a lower return than Buy and Hold also has a max draw-down risk (in theory again since we can never know the reality until it strikes us on our heads) of say 25%, you can safely leverage 2 times or even 3 and yet not fully lose your capital at the worst possible times.

Like Momentum Investing which is hot today because its out-performing the other alternative strategies (are we really I wonder sometimes but that is a question for another time), last year one could see the launch or rocketing up of many trend following strategies built on Nifty.

Way back in 2012, my Job was to Build / Test and Implement trend following strategies on proprietary money. Very soon after we went through a very tough phase of non trending markets (rather the Index). It was tough and yet we came out alive.

The reason we came out alive had less to do with the system (though I am sure helped in a way) but more importantly because we were diversified across multiple Indices and Stocks. While the Index itself was choppy, this was not the case with a few of the stocks and those cushioned our draw-down quite a bit.

Like in Investing, Diversification can save the day for many traders. But there is a problem and that is Capital (not to mention Time). A long while back, I had written a rudimentary post on how much capital would be required (Capital Requirement for a trader).

Since then though, experience (both personal and of others) has taught me that I was very conservative. I think if you really want to be a successful trend follower today, I believe that the capital requirement would come to a Crore of Rupees.

The reason for the high capital is not for the ability to withstand draw-downs but ability to deploy it in multiple Indices / Stocks / Currencies / Commodities. Stocks have a very strong correlation with Index but Currencies and Commodities don’t for most part. By having a broad portfolio of underlying to trade with, you reduce the risk of getting whipped out of one’s capital because one bad underlying one has set out to trade.

A large capital also allows you to trade multiple strategies which further add value (think of trading both a short term trend following vs a long term trend following system for example). But more the strategies and more the underlying on which to trade is not easily possible without a team that can support such an operation or automation.

Trend Following has a very low correlation and hence is an attractive strategy that one can add to one’s arsenal. But it comes with its own caveats and limitations which one should be fully aware of. If you cannot afford a large capital (1 Crore at the minimum), the attractiveness of the strategy goes down faster than the option decay you see on the expiry day. 

PS: The featured image is of the Equity Curve of Dunn Capital. Look at the pain (draw-downs) that have been felt over time (Image Source: Trend Following Performance: Huge Returns).