Last Updated on 10 February, 2024 by Abrahamtolle
The financial landscape is ever-evolving, with strategies constantly emerging to navigate the intricate patterns of the market. One such strategy that has recently gained attention is explored in the research paper titled “Trending Fast and Slow” by Eddie Cheng, Nazar Kostyuchyk, Wai Lee, Pai Liu, and Chenfei Ma.
This article will dissect the methodology employed in the research and shed light on the compelling findings that emerged.
You find many other related articles in our story about The Behavior of Individual Investors.
Methodology Used In The Research
The tactical strategy from “Trending Fast and Slow” takes a unique approach, trading the S&P 500 by dynamically switching between fast and slow momentum based on market volatility. The premise is intriguing – maintaining pace with the S&P 500 while significantly mitigating the impact of the worst drawdowns.
To achieve this, the strategy adheres to a set of rules, which are as follows.
1. Volatility-Based Momentum Switching
The strategy toggles between fast and slow momentum signals based on the current market volatility. In times of high volatility, the fast momentum signal is employed, while periods of lower volatility prompt the use of the slow signal.
2. Monthly Volatility Measurement
On the last trading day of each month, the strategy measures the one-month volatility of the S&P 500 price index using daily data. If the annualized volatility exceeds 17%, it calculates the one-month change in the S&P 500 price index; otherwise, it considers the 12-month change.
3. Decision-Making Tree
The 17% volatility threshold might seem arbitrary, but it stems from a supervised machine-learning technique known as a “decision tree,” as mentioned in the research paper.
4. Position Management
If the change in the price index over the last n-months is positive, the strategy goes long on the S&P 500; otherwise, it moves to cash. The position is held until the last trading day of the following month.
It is worth noting that the original strategy involves going short rather than moving to cash, but the omission of shorting is justified by poor performance in this specific strategy and the challenges associated with shorting in the proposed timeframes.
Key Findings of The Research
The research provides a comprehensive examination of the strategy’s performance, shedding light on the interplay between volatility and momentum. Here are some key insights.
1. Volatility and Long vs. Short Momentum
The success of the “Trending Fast and Slow” strategy is intricately tied to its adept handling of market volatility. In bullish markets characterized by low volatility, the strategy strategically employs longer momentum lookbacks. This choice proves effective in avoiding reactionary responses to short-term market dips, allowing the strategy to ride the waves of longer-term trends.
Conversely, during bear markets or periods marked by high volatility, the strategy shifts gears by favoring shorter momentum lookbacks. This adjustment enables the strategy to respond swiftly to changes in the underlying trend, potentially capitalizing on market downturns or abrupt shifts in sentiment.
2. Performance Metrics
A crucial aspect of evaluating the strategy’s effectiveness lies in analyzing its performance metrics. The research meticulously contrasts the average long/short monthly returns in the SPY for both fast and slow momentum, taking into account the prevailing market volatility.
During low-volatility markets, slow momentum emerges as a robust performer, showcasing its ability to navigate and capitalize on longer-term trends. In contrast, during high volatility periods, fast momentum takes the spotlight by shining amidst turbulent market conditions, emphasizing the strategy’s agility in adapting to changing dynamics.
3. Long-Only Returns
The analysis extends to the realm of long-only returns, providing insights into the strategy’s impact when short positions are excluded. While the effect of slow momentum is less pronounced in this scenario, it offers a distinctive advantage during low or normal volatility markets.
Slow momentum proves to be a steady force, consistently keeping investors in the market and preventing them from being misled by short-term market fluctuations. This underlines the strategy’s capacity to provide a stable and reliable investment approach, particularly in less turbulent market conditions.
4. Volatility Threshold Significance
The significance of the 17% volatility cutoff becomes apparent as it represents the top quintile of historical observations. In nearly 81% of instances, the market operates within a low or normal volatility state.
This contextualizes the chosen threshold, indicating that the strategy’s application aligns with a substantial portion of historical market conditions. The threshold serves as a practical guide, offering a meaningful benchmark for the strategy’s decision-making process.
5. Market Behavior Over Time
Examining historical data since 1954 sheds light on the fluctuating nature of market volatility. The data illustrates extended periods during which market volatility remains below the 17% threshold. These periods, characterized by relative stability, are abruptly interrupted by spikes in volatility.
This temporal perspective emphasizes the dynamic nature of market conditions, reinforcing the strategy’s adaptability to abrupt changes and its ability to navigate through different phases of market behavior.
The “Trending Fast and Slow” strategy introduces a nuanced approach to navigating market dynamics. However, it raises questions about the balance between simplicity and complexity in strategy design. While the basic concept holds promise, the simplicity of the proposed strategy may fall short in practical application.
As the financial landscape evolves, strategy developers are encouraged to delve deeper, striking the right balance to harness the full potential of this innovative approach.