Trend Following Systems

The Basics

At the most basic level, a quantitative trend following system must define:

• When to enter a position
• How much (eg how many futures contracts) to buy.
• When to exit a position.

Trend followers take positions in markets which their system expects to trend strongly in its favor over time. In contrast to proponents of the efficient market hypothesis, trend followers believe that sustained trends are evidenced in markets as participants take time to fully adjust to changing fundamental factors in world economies. Fundamental shifts do not occur instantaneously and often take considerable time to unfold. Such adjustments often take time to filter through to market participants and one consequence is the relative ease with which robust and elegantly simple trend following strategies can be designed to profit from the resultant trends. A trend following strategy involves initiating a position in a trending market, holding that position while the trend lasts and liquidating positions either when a stop loss is hit or when the trend followers systems perceive that a trend has ended.

Trend following is often summarized as “running your profits and cutting your losses”. It sounds simple enough (and conceptually it is) but it takes some years of intensive research and practical investment experience to fully understand the methodology.

Longer term systems tend to be more durable over time and are cost effective in terms of slippage and commissions – the slower the turnover of the portfolio and the fewer contracts you need to buy the less vulnerable you are to the frictional costs of investment. Short term systems in general have a much shorter shelf life – they seem to be less stable and are often fitted to more specific market situations and thus need constant change over time in order to maintain profitability. Short term systems involve far greater portfolio turnover and are thus subject to proportionately greater costs.

Entry and Exit Signals

Trend followers use precise mechanical rules to determine entry and exit points. The precise entry and exit rules determine when a trend (as defined by the system parameters) is likely to have commenced and when the trend is likely to have ended.

Entry and Exit signals are based on mathematically derived technical indicators. It is only after the event that a trend can be seen – by inspecting the charts. A manager must decide in advance what length or lengths of trend he is aiming to profit from and must design algorithms to capture or follow such trends. The use of relatively limited data in a technical indicator (20 day’s closing prices for instance) will ensure that the indicator follows market prices relatively closely and will result in chasing shorter term trends and a comparatively swift turnover of positions. Extending the number of days used in the calculation out to 300 days (by way of example) will result in the system following much longer term trends – the system will be slower moving with far less turnover.

The following example gives Entry and Exit Rules for a mechanical system of extreme simplicity:

• Entry Rule: Enter a Long position at the market open tomorrow if today’s close is above the Moving Average.
• Exit Rule: Exit the Long position at the market open tomorrow if today’s close is below the Moving Average.

The following illustration shows the trades which would have been executed by this basic system in Crude Oil futures if the Moving Average had been calculated using closing prices for a 20 day period. Note the relatively high turnover of positions during February through to May 2010 – this is a relatively “fast” system aiming to catch relatively short term trends.

The following chart illustrates exactly the same rules but uses a much longer term 300 day period in the calculation of the moving average. Note that extending the period of calculation reduces the number of trades during this period to a single continuing position:

Future posts will go on to describe:

• How much to buy.
• Volatility Based Stops.
• Profit Taking.
• Leverage.
• Risk.