The Second Leg Down

Chapter 6Trend Following as a Portfolio Protection Strategy

“If you want to make a million you don't have to understand money, what you have to understand is people's fears about money.”

-William Gaddis, JR

In this chapter, we discuss how trend following can be used as a risk mitigation device after a market drop. It offers a potential alternative to long options strategies, particularly when the cost of insurance (i.e. implied volatility) is already high. We describe what the catch-all phrase “trend following” means, both in practical and philosophical terms. We study momentum from a variety of perspectives, calculating correlations with volatility indices and pushing the analogy with insurance as far as we can. Our conclusions will not be definitive, but will give some insight into the complex relationship between momentum and portfolio protection. Ultimately, we argue that trend following is a moderately reliable form of statistical insurance. There is no guarantee that your trend following system will be up during a rapid sell-off. However, trend following is structurally diversifying, with a high probability of strong performance during sustained bear markets.

Trend following benefits from price volatility when the signal to noise ratio is high. A market that shoots off in one direction or another, without too much choppiness en route, is ideal. Conversely, volatile range-bound markets are just about the worst environment for a trend follower. A system is likely to get “topped ...