My Hedged Fund - Another "Trend-Following" Post

How do we handle volatility in a trend following system? Well of course, it depends. Periods of high volatility create a big opportunity for traders who use short-term trend following systems and can be extremely profitable with proven systems in the right hands. These traders look for periods where trends are quickly formed; profit opportunities abound. The reader of this post no doubt recognizes the similarities between the two charts below; they depict the 1-day (28 January 2011) RSX trend and the 3-year (1929-32) US:INDU trend.




While the correlation may not be 100%, the point should be clear: trends exist in the short term (in the order of hours), the long-term (in the order of years), and in between. Someone following hourly trends becomes by definition a “daily trader” while those following long-term trends could be confused with the “buy and hold” crowd. I personally fall in the “in between” category, where I follow monthly trends which require me to trade on a weekly basis.


Volatility uses – Volatility is very important to me both from a system and mental health perspective. In “Week 2” I outlined (referencing Taleb’s work) some of the reasons why I don’t use a “daily” trend following system, with my lack of ability to profitably handle extreme volatility being key. Long-term trend following systems are of significant value, but the boredom factor (too little volatility?) then rears its head. So I’ve known for quite some time now that I need some volatility in order to succeed as a trader.

How do I use volatility? I have described before how my selection of asset classes are based on simple moving average combinations; volatility uses for me revolve mostly around pyramiding and selling decisions.

- Selling – while I use traditional MA crossovers as selling signals, they are supplemented at times by the use of the Average True Range (ATR), which of course is itself a volatility measure.
- Example – suppose there is a $10 asset (A1) with a 0.10 ATR and another $10 asset (A2) with a 0.20 ATR. A trader who uses a -10ATR sell signal would sell A1 when it reaches $9, while he would do so at $8 for A2. This is an indirect volatility play, which forms a part of my strategy today.
- Pyramiding – how do traders add to their investments? There are many ways. One of the variables I use is the basic Standard Deviation / Price, which is of course a volatility play as well.


Of the readers I ask, what volatility measures do you use? Which ones should I consider using in the ETF trading front?


Current Positions

I chose the volatility topic for a reason; the markets certainly witnessed a significant amount of volatility this week, particularly so towards the end of the week. This volatility caused sell signals for the Malaysia position (2nd block sale will be carried at the open on Monday) and reductions in the Russell 2000 (TNA) position. I added positions on Technology (TYH), Large Cap Growth [NASDAQ (TQQQ)], and a second block on Industrials (XLI).

Those interested could find the details of my current positions here.

Performance for the week was just about flat (up 0.01%), although it had been up over a little over 4% just the day before (volatility at its best.)

“My Hedged Fund” performance – Week - up 0.01%, YTD - down 0.63%

Total World Stock (ACWI) – YTD - up 0.04%

S&P 500 (SPY) – YTD - up 1.57%

European, Australasian and Far Eastern Markets (EFA) – YTD - up 1.22%

Commodities (GCC) – YTD - up 2.03%



What Next Week May Bring

Coal (KOL), Mexico (EWW), Transportation (IYT), Home Construction (ITB) and Consumer Discretionary (XLY) trends are deteriorating; I may see selling signals next week. I may buy into the Dow Jones U.S. Real Estate Index (IYR), MSCI Sweden Index (EWD) or the Swiss Franc (FXF) next week as trends are moving in the right direction at this time; I may add to my Energy (ERX) and Agriculture (DBA) as well.

Feedback and commentary are as always welcomed.

Happy trading from Boston,


Boston

I recently added correlation to S&P daily returns to my backtest code. For a long run (10 years) I get -0.15 or so, which sounds about right. Any idea what your historical correlation is?

Hi Boston, an interesting article again. Do you have a way of measuring your Counterparty Risk? I ask as during the financial crisis in 2008 the ETFs I held from one provider were suspended for a while as the counterparty for them was AIG. The ETF provider have since changed the structure to have multiple counterparties. But I wondered if this was something you considered when looking at the balance of your fund. Do you know how much risk you have with a single bank?

Hi Isatrader,

I actually do not have a way to measure it, although would certainly love to learn about how to do so. There are several articles (#1) (#2) that provide some background on the topic of "Counterparty risk" but limited guidance on how to actually measure it. Article #1 above alludes to less risk being present in ETF's backed by actual physical replication of an Index vs "synthetic replication" (through the use of derivatives), but this is still just a qualitative assessment of risk.

Anyone else has thoughts on the topic? Seems like a good Thesis project...

Boston

Boston, out of interest, why are you so convinced that trend following will continue to work? It has in the past, but as we know, this is no guarantee of future behaviour. Could you explain to us your belief system behind your approach to markets?

Belief System behind Trend-Following

• History repeats itself – while we tend to use the phrase from a risk management perspective (meaning “don’t ignore the past as it could come back to haunt you”), the opposite is also true… trend-following systems have worked in the past… they should continue to work in the future.
• Price action – a solid trend, confirmed by multiple trend lines, comes across to me as a strong predictor of future performance. Could the trend turn around the minute you buy it? Of course it can, and it does, but the probability is greater that it will continue.
• Case in point – the chart below is that of a major sector taken today, 31 JAN 11. I personally feel very comfortable putting some capital here. Could the trend reverse? Of course, but I find it more likely than not that it will continue.



• Economic growth – I believe that the global economy, in the long-term, will grow; it is the “mother trend.” [One could argue that traditional “buy and hold” investors are following a trend, the difference being that the rationale for those investors in based more on “fundamentals,” while ours is based (or should be based) on price movement alone.] Trend-following is then all about extracting more from the “mother trend” by identifying sub-trends (of the hours, days, months variety) within it and trading them.

It could be argued that these conditions (economic growth, price action, etc) are a reflection of human behavior, and therefore unlike to drastically change, although they will certainly evolve. If one assumes the system is well designed (risk management protocols in place, well diversified and capitalized) and if one assumes discretion is kept to a minimum (kept in place only to address potential evolution in human behavior), then trend-following systems should continue to work, maybe for a while longer.

In the end though, the Earth is flat, GM can never go broke, and a little kid with a mom from Kansas and a dad from Kenya can never be President of the U.S. My eyes are wide open.

Boston

Yes, these are all reasons I've used in the past to justify this style of trading to myself.

Human beings don't change and as such, there will always be trends.

However, I wonder if a little more work needs to be done here. You know your style of trading; is there any evidence to show that the OPPOSITE of your style of trading loses money? If we can show that, then that adds to the argument.

Week 5 - Shorting ETF’s; theoretically easy to do…

First some background, leveraged from the following sources:

Investopedia - Shorting ETFs: Profit Or Peril?
ETF Trends – Shorting ETFs Without the Risk, and
Index Universe - Shorting ETFs Misunderstood, Even By A Ph.D.

The Basics of shorting ETF’s – as with stocks, shorting an ETF requires that you borrow the shares that you want to sell. The broker may borrow the securities from another client or from another firm, and the ETF is sold on the market. The hope of course is that the market will fall. The decline will cause the price to drop, allowing for the ETF to be repurchased at a lower price.


Advantages of Shorting ETFs:

- ETFs are said to be easier to short than stocks because they're not subject to the "uptick" rule, where shares cannot be shorted unless their prices first rise.
- ETF’s also are not affected by short squeezes which occur when the price of the stock starts on a quick rise when the supply is lacking. Traders with short positions try to buy stocks to prevent losses, which only spikes the prices even further, making the losses of those who shorted and didn't close their positions even worse. ETFs don't suffer from this because of the number of shares that can be increased (theoretically) on any trading day.

Disadvantages:

- The process can be difficult to execute
- Not all ETFs can be shorted, and some are hard to short, as it is difficult to do so in small quantities.

Alternatives:

- Use Inverse ETFs - Some people have gravitated to inverse ETFs, which are also known as short ETFs. They are of course designed to go up when a particular sector or index declines. These ETFs provide all the benefits of short selling, but don't require that you make a direct short sale.
- If there is no 1X inverse available, one could trade half the dollar amount in a 2X inverse
- Open multiple brokerage accounts for your shorts and use these other accounts for the times your primary broker does not have the ETF or stock available. 

Why do I bring the topic up? It impacted me this past week of course.

I’ve been watching the deterioration of EPI (India) for some time, creating a very nice trend. All indicators pointed towards a buy signal on the short side, which I received early in the week. I proceeded to place the order, which was “rejected” within a couple of minutes. I tried again, and was rejected again. After trying four times I called the broker directly who indicated that there were no shares available for sale, this with the “short interest” level at almost 4MM! My options were to either keep trying or to drop the interest in the short.

To make a long story short (no pun intended), I was not successful in completing the transaction, opting instead for INDZ, an India inverse (and leveraged) ETF.

Any readers come across similar challenges? What workaround, if any, have you been able to develop?


Current Positions

I completed the following transactions last week:

- Sold EWM (Malaysia) – completed sale signaled at the end of last week
- Sold IYT (transportation) and EWW (Mexico) after hitting technical thresholds
- Bought INDZ (India short) based on technical thresholds
- Added to FCG (natural gas exploration), XLI (industrials), DBA (agriculture), TMV (treasury bear), and NLR (nuclear energy) after receiving “pyramiding” buy signals.

The pyramiding signals created a need for additional funds; I use a “relative strength” algorithm to prioritize sales in situations such as this. The algorithm considers distance between price and MA’s (the greater the better), distance between price and 52-week highs (the smaller the better), and the ETF’s standard deviation. The algorithm provided prioritized sales on KOL (coal), ITB (home construction) and TNA (Russell 2000); those funds were used to fund the additions listed above.

The reader can see all positions in more detail here.



Current performance

Week 5 was the best week of the year so far, with the fund being up almost 8%. Currently invested in 26 assets, with all but one (biotech) showing gains. ERX has performed particularly well, up 24% YTD. Chart with some relevant benchmarks below:




What Next Week May Bring

Only IBB (biotech) appears to be close to giving a sell signal. All other current investments are in what appear to be solid trends. Current investments in EWC (Canada), EWJ (Japan), EWT (Taiwan), FCG (natural gas exploration), JJG (grains) and NLR (nuclear energy) are close to providing additional pyramiding buy signals which could cause me to sell IAI (broker / dealers), XLY (consumer discretionary) and the aforementioned IBB. Any additions to FCG and NLR would "max them out" as per my risk management guidelines (ERX, MWJ and XLI are already maxed out.)

Feedback and commentary are as always welcomed.

Happy trading from Boston,



Boston