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110524_trend

110524_trend

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58
Wilmott
magazine
 A question often asked by investors to fund managers, besides the aver-age return of their strategies, is: “What is your fraction of winningtrades?” Implicitly, they expect the answer to be larger than
50%
, as this would indicate that the fund manager is more frequently right than wrong, and
therefore
trustworthy. We want to show in this paper that thisfraction is in fact meaningless. It depends entirely on the trading style of the manager, and tells very little about the consistency of his returns. Itis clear that one can make money on average even if the fraction
 f 
of win-ning trades is low, provided the average gain per winning trade
G
exceedsthe average loss per losing trade,
L
. The condition is, clearly:
 f 
G
> (
1
 f 
)
L
.
(1)Since asset prices are very close to being pure random walks, any statisti-cal signal exploited by systematic traders has an extremely small signal
Trend followers lose moreoften than they gain
*Electronic address: marc.potters@cfm.fr, jean-philippe.bouchaud@cfm.fr
to noise ratio. The average profit
 per trade
for any hedge fund is bound tobe very small, which means that the above inequality is close to an equal-ity. If the typical holding period of winning trades is
G
and that of los-ing trades
 L
, one expects, for a random walk of volatility
σ 
:
G
σ 
G
,
L
σ 
 L
.
(2)Therefore, the fraction of winning trades is in fact a measure of the ratioof the holding periods of winning trades to that of losing trades:
G
 L
1
 f  f 
2
.
(3)For example, a
40%
fraction of winning trades merely indicates that(unless the manager is really lousy) the typical holding period of winning
Marc Potters
Science & Finance, Capital Fund Management, 6-8 Bd Haussmann, 75009Paris, France
 Jean-Philippe Bouchaud
Science & Finance, Capital Fund Management, 6-8 Bd Haussmann, 75009Paris, FranceService de Physique de l’État Condensé, Orme des Merisiers, CEA Saclay,91191 Gif sur Yvette Cedex, France
 We solve exactly a simple model of trend following strategy, and obtain the analytical shape of the profit per trade distribution. This distribution is non trivial and has an optionlike, asymmetric structure. The degree of asymmetry depends continuously on the parameters of the strategy and on the volatility of the traded asset. While the average gainper trade is always exactly zero, the fraction
 f 
of winning trades decreases from
 f 
=
1
/
2
for small volatility to
 f 
=
0
for high volatility, showing that this winning probabilitydoes not give any information on the reliability of the strategy but is indicative of the trading style.
 
 Wilmott
magazine
59
trades is
2
times that of losing trades. This, in turn, means that themanager is probably mostly trend following, since by definition a trendfollowing strategy stays in position when the move is favorable, but closesit in case of adverse moves. Hence, conditioned to a winning trade, theholding period is clearly longer. The opposite would be true for a contrari-an strategy. Let us illustrate this general idea by two simple models. Thefirst one is completely trivial and not very interesting besides driving ourpoint home. The second model is much richer; it can be solved exactlyusing quite interesting methods from the theory of random walks andleads to a very non trivial distribution of profits and losses. Besides itsintrinsic interest, the model elegantly illustrates various useful methodsin quantitative finance, and could easily be used as a basis for a series of introductory lectures in mathematical finance. The outcome of our calcu-lations is that although the daily P&L of the strategy is trivial and reflectsthe statistics of the underlying, the P&L of a
 given trade
has an asymmetric,option-like structure!The first model is the following: suppose that the price, at each timestep, can only move up
+
1
or down
1
 with probability
1
/
2
. The trendfollowing strategy is to buy (sell) whenever the last move was
+
1
(
1
) andthe previous position was flat, stay in position if the last move is in thesame direction, and close the position as soon as the move is adverse.Conditioned to an initial buy signal, the probability that the position isclosed a time
n
later is clearly:
 p
n
=
(
1
/
2
)
n
.
(4)If 
n
=
1
, the trade loses 1; whereas if 
n
>
1
, the trade gains
n
2
.Therefore, the average gain is, obviously:
n
=
1
(
n
2
)(
1
/
2
)
n
=
0
,
(5)as it should, whereas the probability to win is
1
/
4
, the average gain per winning trade
G
is
2
and the average loss per losing trade
L
is 1. The aver-age holding period for winning trades is:
G
=
4
n
=
3
n
(
1
/
2
)
n
=
92
.
(6)Let us now turn to our second, arguably more interesting model, where the log-price
 P 
(
)
is assumed to be a continuous time Brownianmotion. This model has well known deficiencies: the main drawbacks of the model are the absence of jumps, volatility fluctuations, etc. thatmake real prices strongly non-Gaussian and distributions fat-tailed
1
.However, for the purpose of illustration, and also because the continu-ous time Brownian motion is still the standard model in theoreticalfinance, we will work with this model, which turns out to be exactly sol-uble. We assume that on the time scale of interest, the price is driftless,and write:
dP  P 
=
σ 
dW 
(
),
(7) where
dW 
(
)
is the Brownian noise and
σ 
the volatility. From these log-returns, trend followers form the following “trend indicator”
φ(
)
, obtainedas an exponential moving average of past returns:
φ(
)
=
σ 
 
−∞
e
(
)/τ 
dW 
(
),
(8) where
τ 
is the time scale over which they estimate the trend. Large posi-tive
φ(
)
means a solid trend up over the last
τ 
days. Alternatively,
φ(
)
can be written as the solution of the following stochastic differentialequation:
d
φ
=
1
τ φ
dt 
+
σ 
dW 
(
).
(9)The strategy of our trend-follower is then as follows: from being initiallyflat, he buys
+
1
 when
φ
reaches the value
(assuming this is the firstthing that happens) and stays long until
φ
hits the value
, at whichpoint he sells back and takes the opposite position
1
, and so on. An alter-native model is to close the position when
φ
reaches 0 and remain flatuntil a new trend signal occurs. The profit
G
associated with a trade is thetotal return during the period between the opening of the trade, at time
o
(
φ(
o
)
=±
) and the closing of the same trade, at time
(
φ(
)
=
).More precisely, assuming that he always keeps a constant investment levelof 1 dollar and neglecting transaction costs,
G
=
 
o
σ 
dW 
(
).
(10) We are primarily interested in the profit and loss distribution of thesetrend following trades, that we will denote
(
G
)
. A more completecharacterization of the trading strategy would require the joint distri-bution
(
G
,
)
of 
G
on the one hand, and of the time to complete atrade
=
o
on the other; this quantity is discussed in the Appendix. Obviously,
G
and
φ
evolve in a correlated way, since both aredriven by the noise term
dW 
. For definiteness, we will consider belowthe case of a buy trade initiated when
φ
=+
; since we assume theprice process to be symmetric, the profit distribution of a sell trade isidentical. Now, the trick to solve the problem at hand is to introducethe conditional distribution
 P 
(
 g 
|
φ,
)
that at time
, knowing that thetrend indicator in
φ
, the profit still to be earned between
and
is
 g 
.This distribution is found to obey the following
backward
Fokker-Planckequation:
 P 
(
 g 
|
φ,
)
=
φτ 
 P 
(
 g 
|
φ,
)∂φ
+
σ 
2
2
2
 P 
(
 g 
|
φ,
)∂φ
2
2
2
 P 
(
 g 
|
φ,
)∂φ
 g 
+
2
 P 
(
 g 
|
φ,
)
 g 
2
.
(11)However, since
φ
is a Markovian process, it is clear that the history is irrele- vant and at any time
, the distribution of profit still to be made only
^  
TECHNICAL ARTICLE2
 
60
Wilmott
magazine
depends on how far we are from reaching
φ
=
, that is,
 P 
(
 g 
|
φ,
)
dependson
φ
but not on
. Therefore, one finds the following partial differentialequation:
φ
 P 
(
 g 
|
φ)∂φ
+
σ 
2
τ 
2
2
 P 
(
 g 
|
φ)∂φ
2
2
2
 P 
(
 g 
|
φ)∂φ
 g 
+
2
 P 
(
 g 
|
φ)
 g 
2
=
0
.
(12)Eq. (12) has to be supplemented with boundary conditions: obviously when
φ
=
the yet to be made profit must be zero, imposing:
 P 
(
 g 
|
φ
=
)
=
δ(
 g 
).
(13)The final quantity of interest is the profit to be made when entering thetrade, i.e:
(
G
)
=
 P 
(
 g 
=
G
|
φ
=+
).
(14) We now proceed to solve Eq. (12). First, it is clear that all the results canonly depend on the ratio
/σ 
√ 
τ 
, i.e. on the width of the trend following‘channel’
measured in units of the typical price changes over thememory time
τ 
, that is, the order of magnitude of the expected gains of the trend following strategy. One expects in particular that in the limit
/σ 
√ 
τ 
, the distribution of gains will become Gaussian, since thetime needed to reach the edge of the channel is then much larger thanthe memory time of the process. We will from now on measure
and
G
in units of 
σ 
√ 
τ 
, and therefore set
σ 
2
τ 
=
1
hereafter. Now, Fourier trans-forming
 P 
(
 g 
|
φ)
 with respect to
 g 
:
 P 
(
 g 
|
φ)
=
 
d
λ
2
π
e
i
λ
 g 
λ
(φ),
(15)one obtains an ordinary differential equation for
λ
(φ)
:
2
λ
(φ)∂φ
2
2
+
i
λ)∂
λ
(φ)∂φ
λ
2
λ
(φ)
=
0
.
(16)This is known as the Kummer equation (or, after a simple transforma-tion, as the Weber equation)
2,3
. The general solution is the sum of twoconfluent Hypergeometric functions
1
 F 
1
, with coefficients that are deter-mined by two boundary conditions. We already know that the boundarycondition at
should be
λ
(
)
=
1
,
λ
. The second boundary condi-tion turns out to be that
λ
(φ)
should be well behaved for
φ
, i.e.not grow exponentially with
φ
. A way to be convinced and get some intu-ition on the solution is to expand
λ
(φ)
for small
λ
as:
λ
(φ)
=
ψ
0
(φ)
+
i
λψ
1
(φ)
λ
2
2
ψ
2
(φ)
+
...
(17)Plugging this into Eq. (16), one finds:
ψ
0
(φ)
1
;
ψ
1
(φ)
0
;
ψ

2
2
ψ
2
=
2
.
(18)The first two results are expected and simply mean that
 P 
(
 g 
|
φ)
is normal-ized for all
φ
, and that the average gain is identically zero, as must indeedbe the case of any strategy betting on a random walk. The last equationis more interesting; the only reasonable solution of this equation is:
ψ
2
(φ)
=
2
 
φ
d
ue
u
2
 
u
d
ve
v
2
,
(19) which for large
φ
behaves as
ln
φ
. This is indeed expected: if the trade didopen when
φ
hits a very large value instead of at
+
, the time needed for
φ
to come back to values of order
can be obtained by solving Eq. (8) without the noise term, giving
τ 
ln
φ
. The total gain is the sum of 
/τ 
random contributions, its variance is thus expected to be
ln
φ
. Infact, in the limit
φ
, the distribution of gains indeed becomes exact-ly Gaussian, as can be seen by writing:
λ
(φ)
=
e
λ
22
λ
(φ)
.
(20)The corresponding
ODE
for
 Z 
λ
(φ)
reads:
λ
2
2
2
+
i
λ
 Z 
 Z 

+
2
φ
 Z 
2
=
0
,
(21)from which one immediately finds that for
φ
,
 Z 
ln
φ
independ-ently of 
λ
. Therefore, in that limit, the characteristic function
λ
(φ)
indeed becomes Gaussian (in
λ
and thus in
 g 
). The above equation on
 Z 
 will be useful below to extract the large
λ
behaviour of 
λ
. The conclu-sion of this analysis is that the large
φ
behaviour of 
λ
(φ)
is a decreasingpower-law:
λ
(φ)
φ
λ
2
/
2
.
(22)This gives us our second boundary condition. The correct solution of ourproblem can then be written as:
λ
(φ)
=
λ
(φ)
λ
(
),
(23) with
the following combination of hypergeometric functions:
4
λ
(φ)
=
1
 F 
1
λ
2
4
,
12
,
+
i
λ)
2
2
λ
2
4
+
12
λ
2
4
+
i
λ)
1
 F 
1
λ
2
4
+
12
,
32
,
+
i
λ)
2
,
(24)related to the so-called the Weber function
3
. One can check, using theknown asymptotic behaviour of the hypergeometric functions, that thisparticular combination indeed decays as
φ
λ
2
/
2
for large
φ
.From these expressions, one can reconstruct the whole distribution
(
G
)
, that we now describe. As already mentioned above, in the limit

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