"Risk cannot be destroyed, only transformed" has long been a mantra repeated with devotion at Newfound. But sometimes we feel a bit like the monks in Monty Python and The Holy Grail: the message is best solidified with a good thwack afterwards.
For trend-following strategies (at least, on average), March was a meaningful thwack as tail risk for the strategy was realized. Ex-ante, we would not expect trend strategies to do well in two back-to-back sudden reversals (falling 30% from all-time highs within a month and then rapidly rebounding). That does not make the result any more palatable, though.
This week, Nathan asks the question, "can we measure the cost of hedging this tail risk?" Specifically, he compares a trend-following strategy to an option-based strategy designed to specifically hedge the whipsaw risks of the trend strategy. In doing so, he can better quantify the cost of that hedge over time as well as isolate the tail risks of the trend strategy when the hedge is not applied. (PDF)
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What We're Reading
→ TREND REVERSION: "Financial markets across all asset classes are known to exhibit trends, which have been exploited by traders for decades. However, a closer look at the data reveals that those trends tend to revert when they become too strong. [...] We find that trends tend to revert before they become statistically significant. Our key observation is that tomorrow’s expected return follows a cubic polynomial of to-day’s trend strength." Trend, Reversion, and Critical Phenomena in Financial Markets