In a nutshell, Trend Following is a trading strategy that buys (or technically speaking, go ?long?) when prices are in an uptrend and short sell (or technically speaking, go ?short?) when prices are in a downtrend. Unlike other trading and investing strategies, trend following only look at one thing for its buy or sell decisions: price. Also, trend following does not try to anticipate price movements or foresee long-term fundamental outlook?it merely reacts to price behaviour.

Does trend following works? Michael Covel, in his book, Trend Following?How Great Traders Make Millions in Up or Down Markets made a thorough case for this trading strategy. We suggest you read his book if you are interested in the idea of trend following.

However, there are some in the finance industry who claim that trend following is very ?risky.? The underlying reason for such a claim is based in the fact that trend following exhibits very volatile returns. Is there any flaw behind such a claim?

First, how is volatility measured? Standard deviation is most often used for measuring volatility. The calculation of standard deviation requires the statistical mean as one of its input. Here lies the weakness for the claim that trend following is ?risky??the underlying assumption behind standard deviation is that prices follow a normal distribution As we said before in How the folks in the finance industry got the idea of ?risk? wrong!, this assumption is generally not true in practice. Price often moves in trends, and the incidence of extreme movements (e.g. 1987 stock market crash) shows that normal distribution is an invalid assumption. Therefore, according to the assumption of normal distribution, meltdowns like 1929 and 1987 are so rare that they occur once every billions of years (we are not sure of whether it is billions or millions, but you get the idea). Thus, if you believe in trend following, you cannot believe in the idea that volatility that is defined by standard deviation is ?risk.?

One more thing: since most of the financial industry uses the faulty normal distribution example as the basis for measuring ?risk,? we cannot help but feel that perhaps much of the financial risks in the world are being wrongly appraised. If that is the case, the next fat-tail event will indeed draw many nasty surprises.

Tags: Michael Covel, normal distribution, standard deviation, technical analysis, Trend Following, volatility

If you enjoyed this article, get free updates by email or RSS.

This entry was posted on Tuesday, January 30th, 2007 at 10:11 pm and is filed under Investor Education, Trend Following. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.