Trend-Following Trading System: The S&P 500 Trends

Does trend following work in the S&P 500? We recently came across an article called Breaking into the Blackbox: Trend Following, Stop Losses, and the Frequency of Trading: The Case of the S&P 500. It’s written by academics, but in plain language without complicated math, so everyone can understand.

In this article, we look at how you can employ trend-following rules to trade the S&P 500.

What is trend following investing and trading?

Trend following involves finding trends in the marketplace, either by going long or short.

What is a trend? A trend must be quantified depending on the timeframe. Depending on your criteria, a stock can be trending on a weekly chart but not on a daily chart. There is no precise definition of a trend.

The essence of trend following is to quantify by using strict mathematical rules, for example by using a moving average: if the price is above the moving average, then the trend is up. If the price is below the moving average, then the trend is down. However, it is, of course, up to you to define the trend.

Does trend following work on stocks?

This is a question that is very hard to answer because every investor or trader has his or her own definition of a trend. We have seen very little research on individual stocks, but a lot has been done on stock indices, like this article, for example.

Are there any trends in the S&P 500? Let’s see:

Trend following the S&P 500:

The article looked at three trend-following rules for the S&P 500 from July 1988 until June 2011:

1. Simple moving averages ranging from 10 to 450 days.
2. Moving average crossovers where the shorter duration moves above the longer duration average ranging from 25-50 and 150-350 days.
3. Breakout rules, for example, when the index trades at an “x-day high” where x ranges from 10 to 450 days.

Before you continue, you might want to check out the trend-following system we published some days ago:

• A simple trend-following system on the S&P 500

Trend-following questions addressed by the authors in the S&P 500:

The authors of the study wanted to investigate this:

1. Does complexity add any value?
2. Is frequency important? (The number of trades)
3. Do stop-losses improve results?

Trend-following results in the S&P 500:

The main conclusions can be summarized in this table:

When the authors add a stop-loss they got the following results:

Conclusions about trend-following in the S&P 500:

These are the main findings from the report:

Complexity doesn’t add value in trend-following:

Complexity doesn’t add much value. When the length of the averages and breakouts are long (over 150 days – many months) no other criteria add value.

Frequency of trading doesn’t improve trend-following results:

High-frequency data, ie. short time frames, is inferior to longer time frames. Anything less than 100 days increases whip-saws and friction costs. Furthermore, there seems to be no clear advantage in using daily data over monthly data.

Stop-losses don’t improve the results in trend-following:

Stop-losses don’t improve the results. Curtis Faith, one of the star performers of Richard Dennis‘ Turtle project back in the 1980s, concluded the same in his book Way Of The Turtle:

Note that the zero case, which means no stop at all, has the best MAR ratio numbers. In fact, the test with no stops is better for all the metrics: CAGR%, MAR ratio, Sharpe ratio, drawdown, and length of drawdown – every single metric. The same things holds true for a test of the Triple Moving Average system: Every single measure was worse with any stops. The same test of stops applied to the Donchian Trend with time-based exit system yields similar results except that for very large stops of 10 ATR or more, the results are about the same as those for a test with no stops. This certainly goes against the common belief that one must always have a stop.

Drawdowns are inevitable. The best thing is to learn how to deal with it to avoid detrimental behavioral mistakes.

• How to deal with drawdowns

Trading For A Living by Gary Smith had an interesting quote:

Because of my fear of losing trading capital, I would either grab the smallest of profits or get scared out by the slightest of reactions.

You can’t reap the good returns offered by the stock market if you can’t handle drawdowns. It’s that simple.

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FAQ:

– How is a trend quantified, and why is it essential to use mathematical rules?

Trends are quantified based on specific criteria, often using mathematical rules like moving averages. For instance, if the price is above a moving average, it signifies an uptrend, while a price below indicates a downtrend.

– Does trend following work on individual stocks, or is it more effective on stock indices like the S&P 500?

While research on individual stocks is limited, trend following has been extensively studied and applied to stock indices like the S&P 500, showing its potential effectiveness.

– Do stop-losses contribute to improving trend-following results in the S&P 500?

According to the study, stop-losses do not enhance trend-following results. Curtis Faith, a notable trader, reached a similar conclusion, stating that tests with no stops often yield better metrics.