Two Basic Trend-Following Strategies

Instead of lingering too long on the theoretical aspects of constructing trading strategies, in this chapter I use examples that you can replicate and test yourself, so that you can make up your own mind about what works and what does not. I start by introducing two very basic trend-following methods, which have been used at least since the 1970s and perhaps even earlier. These particular methods have been chosen for their simplicity and widespread use, in order to make a point. I intend to demonstrate that these very simple and well known strategies, even without any complex modifications, can achieve results comparable with many of the professional trend-following funds out there. I describe the details of these strategies along with a common position-sizing formula they both use as well as the diversification plan; then we can see how well these strategies perform over time and how they measure up against the competition in the hedge-fund world.

The first strategy we investigate is a real classic and very easy to model and trade. The basis of the strategy is the moving average, that is, the average price for the past X number of days. In this variant of the strategy two moving averages are used with a different number of days used for the look-back period, so that we have one fast-moving average and one slow-moving average. To start off with, let’s use the fairly arbitrary values 10 for the fast-moving average and 100 for the slow-moving ...

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