This post was prompted by Michael Covel’s interview Traders’ Magazine in which he claims that trend followers don’t try to make predictions. This idea that trend followers do not forecast returns is widely and frequently repeated. It is also complete nonsense.
Every trading strategy makes forecasts1. Whether these forecasts are explicit or hidden behind entry/exit rules is irrelevant. All the standard trend following systems can trivially be converted into a forecasting model that predicts returns, because they are fundamentally equivalent.
The specific formulation of the trend following system doesn’t matter, so I’ll keep it simple. A typical trend following indicator is the Donchian channel, which is simply the n-bar highest high and lowest low. Consider a system that goes long when price closes above the 100-day Donchian channel and exits when price closes below the 50-day Donchian channel.
This is the equity curve of the system applied to crude oil futures:
This system can trivially be converted to a forecasting model of the form
the dependent variable y is returns, and x will be a dummy variable that takes the value 1 if we are in a trend, and the value 0 if we are not in a trend. How do we define “in a trend”? Using the exact same conditions we use for entries and exits, of course.
We estimate the parameters and find that α ≃ 0, and β = 0.099% (with p-value 0.013). So, using this trend following forecasting model, the expected return when in a trend is approximately 10bp per day, and the expected return when not in a trend is zero. Look ma, I’m forecasting!
Even without explicitly modeling this relationship, trend followers implicitly predict that trends persist beyond their entry point; otherwise trend following wouldn’t work. The model can easily be extended with more complicated entry/exit rules, short selling, the effects of volatility-based position sizing, etc.Footnotes
- Unless they use random entries/exits.