Do Certain Instruments Trend Better than Others? The Case for the Outlier

Over certain periods of time, some instruments do trend better than others….but then without warning just stop trending and enter protracted periods of mean reversion and general equilibrium.

This can be attributed to the fact that longer term trends are symptomatic of market transitions as opposed to market equilibrium. Markets tend to stabilise for a period of time about an equilibrium where stable conditions dominate and mean reversion towards an equilibrium is the name of the game. These are the environments where predictive trading styles blossom and the price follower tends to suffer protracted drawdowns or many whipsaws. As predictive styles multiply in this context, the alpha associated with this rhythmic mean reversion progressively dilutes per ‘predictive’ participant as the frenzy of increased competition for the predictive market behaviour increases. The impact of the this predictive exploitation starts to exert it’s own impact on market dynamics and quickly the alpha dissipates and the market then transitions to it’s next temporary resting point on it’s never ending journey.

During these unpredictable transitions, the lesser numbers of price follower accumulate wealth at the expense of the dominant predictive trading community who in a coordinated manner, are now rushing to the exit gates as the past market behaviour is no more. Hopefully the transition is of sufficient magnitude to pay for the previous numerous whipsaws and provide a significant wealth surplus to wait for the next transition.

Now this general feature of markets that exhibit ‘punctuated’ periods of equilibrium is common across all liquid markets. To say that some instruments trend better than others is a bit of a misnomer as it depends on the length of time you have been observing them….eg. over 50 years, over 20 years, over 10 years, over 5 years etc… the way around this is to maintain a watchlist and backtest across all instruments over as much data as you can get your hands on eg. 20 years plus.

Then rank your watchlist based on their trending tendency over the past 5 year lookback period or so using a benchmark trend following system (and this is the important bit) that approximates the trend following system you want to apply live. Take the top 10 to 20 of this watchlist or as many as you like in ranked order and define that as your current trading universe……but remember that diversification is so very important to improve your risk-weighted returns…..and the more the merrier.

As time elapses your watchlist ranking will vary and some markets will come into trend and out of trend over time. At least by following this exercise you are adopting a quantitative judgment as opposed to a qualitative or anecdotal one.

Note that this exercise is so much easier when adopting systematic processes as opposed to discretionary processes.

Also note that there are trending conditions and then there are outliers. Most of your alpha in diversified trend following approaches is made with the outliers. They are unpredictable and can happen in any liquid market. General trendiness of a market is simply good to stop you building too much drawdown. They do not really contribute to your overall edge. It is the outlier that pays for em’ all that you should be targeting through setting asymmetrical traps that simply catch them when and if they occur.

One of the major reasons why diversification is so important is that when hunting for outliers, the wider you diversify across markets, timeframes and systems….the better chance you have of catching more outliers. The non-linear impact of outliers to your overall performance metrics is what makes the alpha in this style of trading. If you miss the outliers then the game is like any other trading game and predominantly influenced by ‘noise’ and random luck where you can be lucky, unlucky or never getting anywhere. Markets are mostly efficient….and occasionally unpredictably inefficient. It is the latter market condition that makes this game a wealth builder over time.

Long term success is defined by a very few outliers. This is what separates the very successful from the unsuccessful. Buffet made a killing on a few outliers as did Soros……as did all success stories of the Wizards. These outliers or success stories could never have been predicted….and the bottom line is that luck defined them. The reason they exist however is that you have to play the game to participate in them. To stay in the game 24/7 requires protection of capital at all times…..but an open ended profit condition where you strive for infinite yield with luck. The more you diversify, the more chance you have for a lucky strike.

Trade well and prosper

The ATS mob

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