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Dr. Alex Castaldo

4/2/2005
The Sources of Tr**d F*!!**ing Profits

Read the thread that inspired this post

A sagacious observer of T.F. wrote: The returns to trendfollowing are [...] similar to the returns of other risky assets. The presumption then is that there is some risk premium being earned for the activity, a shorthand of which could be the observation that hedgers are not permitted to lower their risk for free. [...] trendfollowing does not work in stocks since everyone in the stock market has the same profile - profit maximizer. What is required is a happy loser in a market with fat tails due to inelasticity - e.g. hedgers.

This idea that the profits of Tr**d F**!!**wers come from hedgers is plausible and interesting, but let us examine it more closely.

Consider Crude Oil. The price rises, then falls back a little, then rises again, making a new high. At this point the Tr**d F**!!**wers (the Donchian boys) come in long. By assumption, they will make money on average, and their profits will come from the short hedgers, like Exxon corporation selling their crude in the futures market. That s OK with Exxon, they are willing to pay for this price protection.

The problem [and this has been the downfall of all academic theories of futures based on hedging starting with Keynes] is that consumers of the commodity also hedge, and in the opposite direction, buying futures to protect themselves against a price rise. No one knows which is more important at any time (i.e. who has to pay to lower their risk). WHAT EVIDENCE DO WE HAVE THAT IN THE ABOVE SITUATION THE PRODUCERS (short hedgers) ARE THE ONES WITH A GREATER NEED TO HEDGE?

A good lawyer, like Mr. Sogi, could make the following argument for the other side:

At the present time, if the price of oil goes down $5 Exxon corporation will have good profits, if oil goes up $5 EXXON will have unbelievably good profits. If the price of oil goes up $5 Delta Airlines ( a consumer) will probably go bankrupt, if it goes down $5 they will probably squeak through with lousy profits. WHO HAS THE GREATER INCENTIVE TO HEDGE AT THIS TIME? When prices are higher than the consensus of a few months or a year ago it is the consumers who have their back against the wall. They are the ones on their knees praying please, please, don t let the price go up further ; they are the ones who would be willing to pay a price to hedge themselves (what Mr. Wiz calls a G.M.T.F.O. trade, with a negative expectation). Yet your theory says that in this situation it is the producers who pay to hedge. Delta Airlines, coming in on the same side as the Donchs, would be paid to hedge. It doesn't make sense. I rest my case.

In my opinion the source of T.F. profits lies elsewhere.

The thread that inspired the post:

3/15/2005
Victor Niederhoffer on Trend Following:

I am often asked why I donít believe in trends despite the great profits of some selected trend followers. The main reason is that standard measures in statistics like the serial correlation coefficient or runs or Goodman tests for m dependent time series, are designed to test trends. I have not found many market series that show consistent departures from randomness on such tests. Nor more importantly, have I ever found a series that looks like it has a trend, whether it be a moving average or lagged momentum type, that doesnít show some serious evidence for non-randomness as measured by the above mentioned tests.

More terribly, the human mind is very good and capable of finding order in chaos and randomness. And what looks like order and trend is often completely consistent with the above.

Two main points that lead to these optical illusions are the fact that the variance of the sum of n random components is n times the variance of a given random component. So as you get further along in time from the starting point of a random series, the movements away from the beginning seem to be very big and trendy, albeit strictly consistent with randomness. (e.g. see chart below, which is a simulated price process where returns are independently normally distributed with mean 0 and standard deviation of 1).

The second main area of deriving order from chance is the human mind's ability to make multiple comparisons. When it looks at a series, it is very good at finding a million stopping and starting points which taken in isolation do indeed show local non-random trends. However, with all these stopping and starting points, it's bound to happen that the straight line between the two points will seem to "explain".

I am well aware that some markets do show trends (in retrospect), and allow back tested systems to work. But merely because it worked back tested, why should the markets be so kind as to allow those who can draw a straight line between two points to make money in the future. Mr. Bacon would argue against it in the field of horse racing. Presumably the wisdom of the market is at least equal to the deceptive practices of the trainers and horsemen.

Well then, how do I explain the great results of the selected trend followers compared to my own? Those results that the great promoters of systems, seminars and books hold up to my discredit and shame. Well , more power to them. I guess I will always be scratching the back of such well to dos.

 

 

Tim Rudderow Brings Up an Important Counter-Point:

I think the returns to trend following are not, on average, "great" but are in fact reasonably close to the capital market line. That is, on a risk adjusted basis the returns to the activity are similar to the returns of other risky assets. The presumption here then is that there is some risk premium being earned for the activity, a shorthand of which could be the observation that hedgers are not permitted to lower their risk for free.

As to the lack of serial correlation in the data, I think the appropriate model is more of a regime shift or combination of distributions , with unknown state variable. Markets are often in equilibrium, with little or no serial correlation, which mucks up any test based on the entire sample.

Lastly, trend following does not work in stocks since everyone in the stock market has the same profile - profit maximizer. What is required is a happy loser in a market with fat tails due to inelasticity - e.g. hedgers.

 

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