Description

In this episode of "Papers With Backtest: An Algorithmic Trading Journey," we dive deep into the intriguing research paper titled "Does Trend Following Work on Stocks?" that challenges conventional wisdom in the trading community. As algorithmic trading enthusiasts, we often associate trend-following strategies with futures trading, but this episode uncovers the potential of applying these techniques to stocks. Our hosts meticulously analyze a comprehensive backtest conducted on over 24,000 U.S. stocks from 1983 to 2004, ensuring that even delisted companies are included to mitigate survivorship bias.

The discussion revolves around the simplicity of the trend-following strategy, which involves purchasing stocks when they hit an all-time high and employing a 10-day average true range (ATR) trailing stop to navigate market volatility. With a win rate hovering just under 50%, the strategy reveals a compelling narrative: while the number of winning trades may not seem overwhelming, the average profit from winning trades significantly eclipses the losses, culminating in an impressive average expected return of 15.2% per trade held for an average of 305 days.

Throughout the episode, we emphasize the critical role of risk management and discipline in trading. The psychological dimensions of trend following are explored, underscoring that success in this domain is not merely about the numbers but also about maintaining emotional control and adhering to a well-structured plan. As we dissect the findings, we encourage our listeners to consider the implications for their trading strategies and personal risk tolerance.

Listeners will walk away with actionable insights and practical takeaways, empowering them to backtest this trend-following strategy in their own trading endeavors. We highlight the importance of adapting the approach to fit individual trading styles, ensuring that each trader can find their unique balance between risk and reward. Whether you’re a seasoned trader or just starting your algorithmic trading journey, this episode is packed with valuable information and strategies that can enhance your trading game.

Join us in this captivating exploration of trend-following strategies and discover how you can leverage empirical research to inform your trading decisions. Tune in to "Papers With Backtest" and equip yourself with the knowledge to navigate the complexities of stock trading with confidence.

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Transcription

• Speaker #0

  Hello, welcome back to Papers with Backtest podcast. Today we dive into another Algo trading research paper.

• Speaker #1

  Awesome.

• Speaker #0

  Okay, let's unpack this paper titled, Does Trend Following Work on Stocks?

• Speaker #1

  Right.

• Speaker #0

  You know, trend following is a classic strategy, often applied to futures, but does it hold up in the wild world of stocks?

• Speaker #1

  Yeah.

• Speaker #0

  We're about to find out. This paper backtested the idea on over 24,000 U.S. stocks from 1983 to 2004. Wow. And get this, they even included those... delisted companies that most analyses miss.

• Speaker #1

  That's a really important point. Survivorship bias can seriously skew the results of backtests. By including delisted companies, we get a much more accurate picture of how a strategy would have actually performed.

• Speaker #0

  Right. It's like trying to judge a baseball team's batting average by only looking at their home runs. Right. You're missing a whole lot of data. So how did they actually put this trend following strategy to the test?

• Speaker #1

  They kept it surprisingly simple, which I always appreciate. The buy rule was elegant. Buy a stock when it closes at an all-time high. That's your signal that the stock is in a strong uptrend.

• Speaker #0

  Makes sense. Ride that wave. But how do you know when to jump off? You don't want to ride it all the way back down.

• Speaker #1

  That's where the exit strategy comes in. They used a 10-day average true range trailing stop, or ATR for short. Think of the ATR like a customized safety net that adjusts to each stock's volatility. It helps you avoid getting shaken out of a trade by those normal price swings that are just part and parcel of the stock market.

• Speaker #0

  OK, so why specifically a 10-day ATR? Is there something magical about that number?

• Speaker #1

  It's all about finding a balance.

• Speaker #0

  Right.

• Speaker #1

  A shorter ATR, like five days, might lead to more frequent exits, while a longer ATR, like 20 days, could result in giving back more profits when a trend reverses. The researchers likely experimented with different ATR lengths and found that 10 days struck a good balance between responsiveness and risk control.

• Speaker #0

  I like it. Simple and effective. But let's get to the juicy part. Did this strategy actually make money?

• Speaker #1

  Hold on to your hat. Over 22 years, they racked up over 18,000 trades. That's a treasure trove of data. Now, the win rate was just under 50%, around 49.3%. At first glance, you might think, eh, that's not so great.

• Speaker #0

  Right, there's always a but, right.

• Speaker #1

  Here's where it gets really interesting. The average winning trade was more than two and a half times larger than the average losing trade. That's the power of trend following. Letting those winners run, baby.

• Speaker #0

  Okay, I'm starting to see the light here. Yeah. Even though you're not winning every single trade, those big wins can really pack a punch. It's like focusing on hitting home runs instead of just getting base hits.

• Speaker #1

  You got it. And when you crunch the numbers, it translates to an average expected return of roughly 15.2% per trade, held for an average of 305 days.

• Speaker #0

  Wait, hold on. Did you say 305 days? That's almost a whole year. Yeah. I thought trend following was all about short-term momentum plays.

• Speaker #1

  That's a common misconception. Yeah. While some trend following strategies are short-term, this research shows that patience can really pay off. And think about the tax implications holding a stock for over a year often qualifies you for those sweet, sweet long-term capital gains rates.

• Speaker #0

  Now you're talking my language. Not just making money, but keeping more of it. So this simple trend following strategy seems to have some real potential. But I know there's always a catch, right?

• Speaker #1

  Well, the paper stresses the importance of smart portfolio management. They actually implemented a system designed to manage risk effectively. No chasing losses, no getting greedy, and always sticking to those stop losses.

• Speaker #0

  Okay, so discipline is key here. Sounds like this isn't just a set it and forget it kind of strategy.

• Speaker #1

  Exactly. Risk management isn't just about avoiding losses. It's about maximizing your gains over the long run. You need to have a plan for how you're going to handle both the good times and the bad.

• Speaker #0

  Now, the paper also mentioned some interesting visuals they used. Can you walk us through those?

• Speaker #1

  Sure thing. They included charts showing the distribution of those outlier trades over time, those really big winners and losers that fall outside of the expected risk. This helps you see how those extreme trades played out over the years. Were they random or did they cluster during certain market conditions?

• Speaker #0

  Fascinating. So you could see if there were any patterns, like if certain years were particularly good or bad for this strategy.

• Speaker #1

  Precisely. And they also showed the relationship. between portfolio drawdown and remaining risk, which helps us understand how the risk management system actually worked in practice. You know, it's one thing to talk about risk management in theory, but it's another to see how it plays out in a real portfolio over two decades. That's what these visuals provided, a real world perspective.

• Speaker #0

  I love that. They weren't just saying, trust us, this works. They were showing us the data and letting us draw our own conclusions.

• Speaker #1

  Yeah.

• Speaker #0

  So far, it sounds like they've built a pretty compelling case for trend following in stocks. But I'm sure there are some limitations or caveats we should consider. Right.

• Speaker #1

  You're always thinking critically. I like that. Of course, no strategy is perfect. For example, their research didn't delve into short selling strategies. Their focus was solely on long positions, which makes sense because...

• Speaker #0

  Short selling is a whole different ballgame.

• Speaker #1

  Exactly. It comes with a whole host of complexities like forced buy-ins and the challenge of borrowing shares, not to mention the unlimited risk potential. They kept it simple and focused on what they could control.

• Speaker #0

  Makes sense. Shorting is definitely not for the faint of heart. Were there any other limitations they mentioned?

• Speaker #1

  Well, they pointed out that while the average holding period was under a year, the most profitable trades tended to be held for much longer, often qualifying for those tax-friendly long-term capital gains. It suggests that patience is a virtue, even in a momentum-driven strategy.

• Speaker #0

  So it's not just about riding any trend. It's about riding the right trends for the right amount of time. Now, what about diversification? How many stocks were they typically holding in this portfolio?

• Speaker #1

  That's a great question. The number of positions varied over time, but on average, it exceeded that of most mutual funds. They were casting a wide net, looking for those all-time high breakouts across a diverse range of stocks.

• Speaker #0

  So they weren't just betting on a handful of high flyers. They were spreading their risk and looking for opportunities across the entire market. This is all starting to sound pretty promising. So what's the final verdict? Does trend following actually work for stocks?

• Speaker #1

  Based on their research, the evidence is quite strong. Their simple trend following strategy, combined with a robust risk management system, produced impressive hypothetical results. Of course, past performance is never a guarantee of future returns.

• Speaker #0

  Right. That's always the disclaimer. But this definitely gives us something to think about. Trend following is often associated with futures, but it seems like it can be applied to stocks as well.

• Speaker #1

  Absolutely. The key takeaway is that it's not just about the strategy itself, it's about how you implement it. Risk management, diversification, and discipline are crucial for success.

• Speaker #0

  I think you've given us a lot to consider. Now, I'm curious to see how this research would hold up in different market environments. For example, how would it have performed during a recession or a period of high inflation?

• Speaker #1

  Those are great questions. Unfortunately, the research focused on a specific period from 1983 to 2004. To get a more complete picture, we'd need to backtest this strategy across a wider range of market conditions.

• Speaker #0

  That sounds like a challenge for another deep dive.

• Speaker #1

  Indeed. There's always more to explore and learn. You know what's really interesting about this research? It got me thinking about the bigger picture. While this particular study focused on U.S. stocks, the principles of trend following could potentially be applied to other markets as well.

• Speaker #0

  You mean like international stocks? Yeah. Or even other asset classes like bonds or commodities.

• Speaker #1

  Exactly. Imagine using this strategy to ride the wave of a booming emerging market. Right. Or to capitalize on a surge in commodity prices.

• Speaker #0

  Okay. So we'd be looking for the same signals, new all-time highs. Right. And using the same kind of trailing stop based on the ATR.

• Speaker #1

  The principles would be similar. Okay. But you'd probably need to tweak the specific parameters to suit the characteristics of each market.

• Speaker #0

  That makes sense. Different markets have different personalities, right? Some are more volatile. Right. Some are less liquid. Yeah. You wouldn't use the same playbook for a wild bronco as you would for a gentle thoroughbred.

• Speaker #1

  That's a great analogy. You're exactly right. Yeah. For example, if you're trading in a less liquid market. Right. You might need to use a wider stop loss to avoid getting whipsawed out of your positions too early. Okay. Or you might need to adjust your position sizing to account for the lower trading volume.

• Speaker #0

  Right. And you definitely want to be mindful of any currency risks if you're trading international stocks. Those fluctuating exchange rates could really eat into your profits or boost them if you're lucky.

• Speaker #1

  Absolutely. It's all about understanding the unique dynamics of each market and adapting your strategy accordingly.

• Speaker #0

  So while the trend following concept might be transferable, it's not a one size fits all approach. Right. You need to be a bit of a chameleon, blending into each market and adjusting your colors as needed.

• Speaker #1

  Could have said it better myself. Trading is all about adaptation. It's a constantly evolving game, and those who can adapt the quickest tend to thrive.

• Speaker #0

  Speaking of different approaches, I'm curious to hear your thoughts on how this trend-falling research stacks up against other common trading strategies, you know, like value investing or mean reversion.

• Speaker #1

  That's a fascinating question. It's like comparing apples and oranges. They're all fruits, but they taste completely different. Right. Value investing, for example, is all about finding those undervalued companies, those hidden gems that the market has overlooked. Yeah. It's a very different philosophy from trend following, which focuses on price momentum and riding the wave of existing trends.

• Speaker #0

  Right. Value investors are like treasure hunters digging for those buried bargains, while trend followers are more like surfers riding the waves of market momentum. Yeah. They both have their merits, but they require different skills and mindsets.

• Speaker #1

  Precisely. And you know what's really cool? Some investors actually combine elements of both value investing and trend following in their portfolios. It's like having the best of both worlds.

• Speaker #0

  I could see that working. Yeah. You might use a value-based approach to... identify potential candidates, those companies, with strong fundamentals, and then use trend following techniques to time your entry and exit points. So you're not just buying a good company, you're buying it at the right time.

• Speaker #1

  You've got it. It's a powerful combination that can lead to some really impressive results. Right. But it all comes back to knowing yourself as an investor. What are your strengths? What's your risk tolerance? What kind of trading style feels most natural to you? Once you have a good understanding of those things, you can start to build a strategy that aligns with your goals and personality.

• Speaker #0

  I love that holistic approach. Yeah. It's not just about the numbers. It's about understanding yourself and finding a style that you can stick with even when the market throws you curveballs.

• Speaker #1

  Wouldn't agree more. Trading is a marathon, not a sprint.

• Speaker #0

  Now, speaking of staying in the game for the long haul, the paper really hammered home the importance of risk management. What are some of the key takeaways from this research that our listeners should keep in mind when it comes to managing risk? and a trend following strategy?

• Speaker #1

  Well, first and foremost, you need a clear exit strategy. Oh. Know when you're going to sell a stock, even before you buy it. Right. That's where the ATR trailing stop comes in handy. It provides a systematic, unemotional way to protect your profits and limit your losses.

• Speaker #0

  So no second guessing yourself or getting emotionally attached to a stock. Yeah. It's about sticking to the plan.

• Speaker #1

  Exactly. Emotions can be your worst enemy in trading. They can cloud your judgment and lead to impulsive decisions. Having a predefined exit strategy helps you stay disciplined and make rational choices, even when the market is going haywire.

• Speaker #0

  The researchers also stress the importance of never adding to losing trades, which I know can be a tough pill to swallow. It's so tempting to try to average down and buy the dip, but sometimes that just digs you deeper into a hole.

• Speaker #1

  You're absolutely right. It's a classic trap that many traders fall into. They get attached to a losing position and keep throwing good money after bad, hoping for a miracle turnaround. But more often than not, it just leads to bigger losses. It's like trying to put out a fire with gasoline. It rarely ends well.

• Speaker #0

  Instead, they recommend cutting your losses short and moving on to other opportunities. There are always other fish in the sea.

• Speaker #1

  Exactly. The market is full of possibilities. There's no need to cling to a sinking ship.

• Speaker #0

  Another risk management technique they highlighted. was scaling out of winning trades. Can you explain what that means and why it's important?

• Speaker #1

  Sure. Scaling out means gradually reducing your position size as a stock goes up in price. Okay. It's a way to lock in profits and protect yourself from a potential reversal. Think of it like taking some chips off the table while you're ahead in a poker game.

• Speaker #0

  So you're not just riding the trend all the way to the top, you're taking some profits along the way to protect yourself from a sudden downturn. Right. It's like a safety net for your gains.

• Speaker #1

  Precisely. It helps you strike a balance between greed and fear. You want to let your winners run, but you also don't want to give back all those hard-earned profits if the trend reverses.

• Speaker #0

  It seems like diversification is another crucial element of risk management in this strategy. Don't put all your eggs in one basket, right?

• Speaker #1

  Absolutely. By holding a basket of stocks that are exhibiting strong trends, you spread your risk and reduce your exposure to any single company. It's like having a diversified investment portfolio. But instead of different asset classes, you're diversifying across different trending stocks.

• Speaker #0

  So you're not betting the farm on just one or two horses in the race. Right. You're spreading your bets and increasing your chances of coming out ahead in the long run.

• Speaker #1

  Exactly. And even with a well-diversified portfolio, it's crucial to have a clear understanding of your overall risk tolerance. How much drawdown are you comfortable with? What's your time horizon for these investments? These are all important questions to consider before you even start trading.

• Speaker #0

  It's like setting your own personal speed limit before you hit the road. You need to know how fast you're comfortable going and how much risk you're willing to take on.

• Speaker #1

  You're spot on. You need to be honest with yourself about your risk appetite and make sure your trading strategy aligns with your overall financial goals and personality.

• Speaker #0

  This has been a really helpful breakdown of the key principles of risk management in trend following. I think it's easy to get caught up in the excitement of finding winning trades. Yeah. But it's equally important, if not more so, to have a solid plan for managing risk.

• Speaker #1

  I couldn't agree more. Risk management is the foundation of successful trading. Without it, you're just gambling.

• Speaker #0

  Now, I want to shift gears a bit and tap into your expertise on the psychological aspects of trend following. I imagine it takes a certain mindset to be successful with this kind of strategy.

• Speaker #1

  The mental game. That's where things get really interesting. Right. You see, trend following can be quite challenging psychologically because it often goes against our natural instincts. Oh,

• Speaker #0

  so?

• Speaker #1

  Well, most people are wired to buy low and sell high. It seems logical, right? But with trend following, you're doing the opposite. You're buying stocks that are already at all time highs, which can feel counterintuitive.

• Speaker #0

  It's like going against the grain. Right. Everyone else is looking for bargains and you're jumping on the bandwagon of stocks that are already soaring.

• Speaker #1

  Exactly. And then when a stock starts to pull back, you're selling, even though it might seem like a good time to buy the dip. It takes a lot of discipline and mental fortitude to stick to your plan and not get swayed by those emotional urges.

• Speaker #0

  It sounds like you need to have a strong belief in your system and not let fear or greed dictate your decisions.

• Speaker #1

  You nailed it. It's all about trusting the process and not getting caught up in the short-term noise of the market.

• Speaker #0

  So discipline and emotional control are key ingredients in the recipe for success with trend following.

• Speaker #1

  Absolutely. It's a strategy that requires a certain mindset, a willingness to embrace the ups and downs of the market, and to trust that the trends will eventually play out in your favor. Right. It's not for everyone. But for those who can master the mental game, it can be a very rewarding approach to trading.

• Speaker #0

  You've painted a vivid picture of the mental and emotional challenges involved in trend following. I can see why it's not for everyone. It's like being a contrarian. Right. Swimming against the tide of popular opinion.

• Speaker #1

  That's a great way to put it. You need to have the confidence to go your own way, even when everyone else is telling you you're wrong.

• Speaker #0

  Speaking of being wrong, it's important to acknowledge that this research, while insightful, Shouldn't be taken as a guarantee of success.

• Speaker #1

  Right.

• Speaker #0

  There's no magic formula in trading, right?

• Speaker #1

  Absolutely not. Trading is a complex and ever-changing game. What works in one market environment might not work in another. And there are always unexpected events that can throw a wrench into even the best laid plans.

• Speaker #0

  Right. As we always remind our listeners, past performance is not necessarily indicative of future results. Right. It's a cliche, but it's a cliche for a reason.

• Speaker #1

  It's the truth. But even though we can't predict the future, we can learn from the past. Research like this gives us valuable insights into what strategies have worked historically and what factors might contribute to their success. It's like having a map to navigate the treacherous terrain of the market.

• Speaker #0

  I love that analogy. It's not a guarantee that you'll reach your destination. Right. But it sure helps to have a map to guide you along the way. So how can our listeners take this research and apply it to their own trading journeys? What are some... actionable takeaways they can implement right away.

• Speaker #1

  First and foremost, I'd encourage everyone to backtest this trend-following strategy themselves. Don't just take our word for it. Get your hands dirty with the data, test it out on different markets and different time periods, and see how it performs for you.

• Speaker #0

  That's great advice. It's one thing to read about a strategy, but it's another thing entirely to experience it firsthand.

• Speaker #1

  Exactly. And as you're backtesting, pay close attention to the risk management aspects. Experiment with different trailing stop settings. different portfolio allocation strategies, and really understand how these choices impact your results.

• Speaker #0

  So it's not just about finding winning trades. Right. It's about understanding how to protect those wins and manage the inevitable losses.

• Speaker #1

  You got it. Risk management is the foundation of successful trading.

• Speaker #0

  Another key takeaway from this research is the importance of patience and discipline. Trend following is not a get-rich-quick scheme. It's a long-term approach that requires a certain mindset.

• Speaker #1

  It's like gardening. You plant the seeds, you nurture them, and you wait patiently for them to grow. You can't rush the process.

• Speaker #0

  I love that analogy. It's so true. Trading, like gardening, is a process that unfolds over time. It requires patience, persistence, and a willingness to adapt to changing conditions.

• Speaker #1

  Couldn't agree more. And remember, trading is a journey, not a destination. There will be ups and downs along the way, but the key is to learn from your mistakes and keep improving your process.

• Speaker #0

  This has been an incredible deep dive into the world of trend following in stocks. We've covered a lot of ground today, from the technical details of the strategy to the psychological challenges of implementing it.

• Speaker #1

  It's been a pleasure sharing my thoughts and insights with you and our listeners.

• Speaker #0

  Well, thank you so much for joining us. Yeah. It was a pleasure having you here with us today.

• Speaker #1

  Absolutely.

• Speaker #0

  Thanks for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at HTTPS.PapersWithBacktests.com. Happy trading!