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Trend Following
One of the most common rule based strategies in Financial Markets is trend following. There are thousands of studies which show markets trend and it has a ritual following among commodity traders. Trends exist because traders have a natural inclination to buy what has just gone up, and sell what has just gone down. Trend following’s persistence as a strategy attests to it long term success. However, trend following is only one, albeit the most popular, of a number of simple rule based strategies that have over time shown to be profitable.
Counter- Trending
As cycle theory attests markets overshoot and are subject to reversals. Most of the time markets move in ranges which means they are mean reverting, even as they rise and fall. A simple strategy of identifying divergence from a historic mean or rate of change has over time proven to be successful.
Carry Trades
The market exhibits forward rate bias. Currencies with higher interest rates tend to appreciate. The total return from the higher yield differential usually over compensates for any depreciation in the underlying spot rate. A naïve strategy of looking to capture this yield differential has over time proven to have one of the highest betas among simple rule based strategies.
Volatility Arbitrage
Despite its utility, there are problems with the Black-Scholes formula for pricing volatility. The formula cannot account for the fact that we tend to dislike losses much more, about twice as much, as we like winners. This means that people are willing to pay a premium to give away risk. A naïve strategy of selling volatility has a carry like pay off.
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These naïve strategies represent the inherent return or beta from currency but they are not without risk. Indeed, as the chart above suggests, all these simple strategies experience years of under performance. |
