Pairing Forex long term trend followers with stock indexes

In the past whenever I have talked about long term trend followers in Forex trading I have talked about how robust they seem to be but also about how trading them can be so hard due to their statistical characteristics. However – despite being very hard to trade – long term trend followers can play an important role as a part of a broader portfolio as they benefit from a generally very low correlation with stock and bond trading instruments. Today I want to talk more about this and discuss why although Forex long term trend followers may not be ideal strategies on their own, they can add a lot of value to an investor who is more interested in smoothing out the performance of a long term investment portfolio.

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In general long term trend followers are strategies that attempt to catch trends that develop on instruments across the upper timeframes. This generally means trying to catch trends that develop in the daily, weekly or monthly timeframes by using things like moving average crossovers or – more commonly – some form of donchian channel breakout technique. In general long term trend followers aim to buy high and then sell much higher and sell low and then buy much lower, they aim to benefit from substantial extensions of strong momentum which – sadly for those who follow these strategies – are really not that common.

The fact that momentum does not generally hold for significant periods of time is the main issue with these strategies. Although they may catch huge movements from time to time they usually enter positions that are exited with small losses as their stop losses are hit. In general long term trend followers have winning ratios between 20-30% with very high reward to risk ratios that compensate for the strategy’s overall losses. However the problem is that these statistical characteristics generally lead to very long drawdown period lengths that can generally go from 1000 to 3000 calendar days. This means that sometimes a person can be waiting for 5 to 10 years before the big “momentum move” comes over. This is the main reason why people are generally not able to trade long term trend followers, they are simply too painful to survive through.

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The good thing however is that long term trend followers in FX follow momentum that is generally uncorrelated with that of the general stock and bond markets. This means that – as showed in the first image above – a long term trend follower can usually compensate the drawdown periods of a stock index and vice versa. In this example the SPY is traded with the Quimichi trading system – a strategy we developed in Asirikuy in 2010 – which trades with the exact same parameters on the EURUSD, USDJPY, USDCHF and GBPUSD. An equally weight portfolio of the SPY and Quimichi has a Sharpe ratio that is much better than that of either the SPY or the separate system on its own.

Although trading a long term trend follower on its own might be very difficult we can see that as part of a broader portfolio it makes much better sense. Paired with something like the SPY a trading system like quimichi was able to greatly diminish drawdowns both in 1999 and in 2008, which were periods when the stock market faced important crashes but when momentum was strong in currencies. You can see that the maximum drawdown goes from a very large +50% in the SPY to a much smaller value, around 30%, when using the long term trend follower to compliment the stock trading regime. Furthermore the SPY also faced a strong bullish market from 2010 to 2014, while the long term trend follower remained basically flat, compensating the long term trend follower’s longest drawdown.

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What I want to show you here is that the fact that it may be difficult to trade a strategy type on its own due to psychological issues does not imply that the strategy type is useless. Lack of correlations with general bond and equity investments can make something like a long term trend follower very interesting, even if trading it on its own as an entire portfolio investment might not be a very wise decision. Of course if you would like to learn more about systems of these type and how you too can trade them on an FX account please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading.strategies.

 

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