This week, we take a deeper dive into the two primary characteristics of trend following: convexity and its historically positive premium.
In past commentaries, we've circled-the-drain in connecting trend and options. In this commentary, we endeavor to draw a more direct link.
As has been established many times before, trend-following strategies have a payoff profile that closely reflects that of an option straddle.
Why? Well, as it turns out, trend following approximates the strategy a trader would need follow to replicate a straddle.
While the link is not one-for-one (and the strength depends on the assumptions and design of the trend strategy), the link allows us to think of trend following as the payoff of an option profile plus the gamma gain minus gamma loss due to replication.
If that all sounds like Greek to you, don't worry: the commentary requires only the most basic knowledge of options to follow along.
At risk of spoiling the conclusion, the really important takeaway is that the convexity of trend following and the long-term premium trend following has harvested seem to come from two independent sources. And even if you do not believe in the long-term premium, the convexity may still be a worthwhile diversifier.
Check it out online or grab the PDF.
As a reminder, Tom and I will be at the Inside ETFs event in Florida this week. I'll even be giving a talk (Tuesday at 2:50pm ET; Room: Atlantic 1) titled No Pain, No Premium. If you'll be there and would like to meet up, let us know!
Read of the Week
→ RISK: "Convexity is the measure of unbalanced risk so, almost by definition, a negatively convex portfolio will be unstable." Convexity Maven - Guide for the Perplexed
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