We have long argued that trend-following strategies are mechanically convex.
The basis for our argument is that trend following coarsely replicates the payoff of an option straddle. A straddle purchases a put and a call option struck at the same price, profiting when price moves significantly up or down.
In replicating the payoff of this position, trend following inherits the convexity attributes of the option position but is able to avoid the up-front cost of the options.
Of course, risk is never destroyed, only transformed. In moving from options to trend following, we move to a coarse replication. And it is in that coarseness that significant deviations in results can emerge.
This week, my co-PM Nathan Faber explores these differences. He creates a number of naive trend following strategies of varying speeds as well as their corresponding straddle strategies using options on the S&P 500. In doing so, he aim to highlight the risk trade-offs of each approach. (PDF).
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