CHAPTER 5
Divergence and the Tradability of Trend
Risk taking is at the core of human experience. When dealing with and processing risk, we use a variety of strategies and techniques to help us handle the risks we face. At the core, our risk-taking strategy is dependent on our belief in the structure of financial markets, also called our financial worldview. When this is taken into account, risk-taking strategies can be divided into convergent and divergent. These two approaches encompass the two basic of types of risk taking. In this chapter, the basic tenets of risk and uncertainty are reviewed to explain how and when our particular financial worldview may lead us to use both convergent and divergent strategies. Convergent and divergent risk-taking strategies can be easily connected to the adaptive markets hypothesis allowing for a clearer understanding of their use over time. Trend following is a divergent risk-taking strategy, which profits from market divergence. Market divergence is discussed and a simple portfolio level measure the market divergence index (MDI) is defined. Empirically, both market divergence and the speed of market divergence are stationary over time. These empirical results suggest that market divergence is a normal phenomenon in financial markets. Finally, the role of predictability and tradability of trend following strategies are examined to show how both predictability and tradability vary over time.
divergence the process that market participants ...
