Posts Tagged ‘standard deviation’

Is trend following trading risky?

Tuesday, January 30th, 2007

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.

How the folks in the finance industry got the idea of ?risk? wrong!

Wednesday, January 17th, 2007

In our previous article, How do you define risk?, we put forth our criticism on the way risk is measured by many in the financial service industry. Today, we will look at the underlying theory behind their measurement of risk. The recommended reading for today will be How the Finance Gurus Get Risk All Wrong.

As you may have noticed, ?risk? is often expressed as a nice and simple number in the world of finance. For example, in many stock research publications, the ?risk? of a stock may be defined in terms of a number called the beta. You may see risk jargons like standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk and so on. All these mathematical definitions of ?risk? give it a scientific feel, which seem to give us the impression that ?risk? can be measured and controlled. Unfortunately, in reality, these definitions and measurements of ?risk? are pseudo-science. The reason is because the underlying theory behind all of them is flawed in the first place.

What are the assumptions behind these conventional measures of ?risk?? They are all based on the assumption that price follows a statistic device known as the normal distribution. If a stock price follows a normal distribution, it means that at any given day, there is a 50% chance that it will go up and a 50% chance that it will go down by the same amount on average. In the long run, the vast majority of stocks? price will hover around its average, with a smaller percentage deviating from it. In other words, the behaviour of stocks? price will follow a bell curve like this (horizontal axis?stock price, vertical axis?probability of the price being at that level):

Bell curve

Is this a valid assumption?We doubt so. As you can see for yourself in the real market, prices often do not follow such behaviour?frequently, they move in trends and at times, exhibit extreme behaviour. As the article in the suggested reading (How the Finance Gurus Get Risk All Wrong) said,

The inapplicability of the bell curve has long been established, yet close to 100,000 MBA students a year in the U.S. alone are taught to use it to understand financial markets.

Thus, as contrarians, this is not the way we define risk.