Straddles and Trend Following: Case #10166365

Straddles and Trend Following
May 11th, 2020
Summary
• The convex payoff profile of trend following strategies naturally lends itself to comparative analysis with option
strategies. Unlike options, however, the payout of trend following is not guaranteed.
• To compare and contrast the two approaches, we replicate simple trend following strategies with corresponding option
straddle strategies.
• While trend-following has no explicit up-front cost, it also bears the full brunt of any price reversals. The straddle-
based approach, on the other hand, pays an explicit cost to insure against sudden and large reversals.
• This transformation of whipsaw risk into an up-front option premium can be costly during strongly trending market
environments where the option buyer would have been rewarded more for setting a higher deductible for their implicit
insurance policy and paying a lower premium.
• From 2005-2020, avoiding this upfront premium was beneficial. The sudden loss of equity markets in March 2020,
however, allowed straddle-based approaches to make up for 15-years of relative underperformance in a single month.
• Whether an investor wishes to avoid these up-front costs or pay them is ultimately a function of the risks they are willing
to bear. As we like to say, “risk cannot be destroyed, only transformed.”
Newfound Research LLC | 380 Washington Street, Second Floor | Wellesley Hills, MA 02481 | p: 617-531-9773 | w: thinknewfound.com
Case #10166365
May 11th, 2020
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Case #10166365
May 11th, 2020
We often repeat the mantra that, “risk cannot be destroyed, only transformed.” While not being able to destroy risk seems
like a limitation, the assertion that risk can be transformed is nearly limitless.
With a wide variety of investment options, investors have the ability to mold, shape, skew, and shift their risks to fit their
preferences and investing requirements (e.g. cash flows, liquidity, growth, etc.).
The payoff profile of a strategy is a key way in which this transformation of risk manifests, and the profile of trend following
is one example that we have written much on historically. The convex payoff of many long/short trend following strategies
is evident from the historical payoff diagram.
Source: Newfound Research. Payoff Diversification (February 10th, 2020). Source: Kenneth French Data Library; Federal Reserve Bank of St. Louis.
Calculations by Newfound Research. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including,
but not limited to, management fees, transaction fees, and taxes. The 60/40 portfolio is comprised of a 60% allocation to broad U.S. equities and a 40%
allocation to a constant maturity 10-Year U.S. Treasury index. The momentum portfolio is rebalanced monthly and selects the asset with the highest prior
12-month returns whereas the buy-and-hold variation is allowed to drift over the 1-year period. The 10-Year U.S. Treasuries index is a constant maturity
index calculated by assuming a 10-year bond is purchased at the beginning of every month and sold at the end of that month to purchase a new bond at
par at the beginning of the next month. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales
charges. Past performance is not indicative of future results.
This characteristic “V” shape in the diagram is reminiscent of an option straddle, where an investor buys a put and call
option of the same maturity struck at the same price. This position allows the investor to profit if the price of the underlying
security moves significantly in either direction, but they pay for this opportunity in the option premiums.
Case #10166365
May 11th, 2020
Source: theoptionsguide.com
The similarity of these payoff profiles is no coincidence. As we demonstrated in Trend – Convexity and Premium (February
11th, 2019), simple total return trend following signals coarsely approximate the delta of the straddle. For those less familiar
with the parlance of options, delta is the sensitivity in the value of the options to changes in the underlying stock. For
example, if delta is +1, then the value of the option position will match price changes in the underlying dollar-for-dollar. If
delta is -1, then the position will lose $1 for every dollar gained in the underlying and vice versa (i.e. the position is effectively
short).
How does this connection arise? Consider a naïve S&P 500 trend strategy that rebalances monthly and uses 12-month
total returns as a trend signal, buying when prior returns are positive and shorting when prior returns are negative. The key
components of this strategy are today’s S&P 500 level and the level 12 months ago.
Now consider a strategy that buys a 1-month straddle with a strike equal to the level of the S&P 500 12 months ago. When
the current level is above the strike, the strategy’s delta will be positive and when the level is below the strike, the delta will
be negative. What we can see is that the sensitivity of our options trade to changes in the S&P 500 will match the sign of
the trend strategy!
There are two key differences, however. First, our trend strategy was designed to always be 100% long or 100% short,
whereas the straddle’s sensitivity can vary between -100% and 100%. Second, the trend strategy cannot change its
exposure intramonth whereas the straddle will. In fact, if price starts above the strike price (a positive trend) but ultimately
ends below – so far as it is sufficiently far that we can make up for the premium paid for our options – the straddle can still
profit!
In this commentary, we will compare and contrast the trend and option-based approaches for a variety of lookback horizons.
Case #10166365
May 11th, 2020
Methodology and Data

For this analysis, we will use the S&P 500 index for equity returns, the iShares Short-term U.S. Treasury Bond ETF (ticker:
SHV) as the risk-free rate, and monthly options data on the S&P 500 (SPX options).
The long/short trend equity strategy looks at total returns of equities over a given number of months. If this return is positive,
the strategy invests in equities for the following month. If the return is negative, the strategy shorts equities for the following
month and earns the short-term Treasury rate on the cash. The strategy is rebalanced monthly on the third Friday of each
month to coincide with the options expiration dates.
For the (semi-equivalent) straddle replication, at the end of each month we purchase a call option and a put option struck
at the level of the S&P 500 at the beginning of the lookback window of the trend following strategy. We can also back out
the strike price using the current trend signal value and S&P 500. For example, if the trend signal is 25% and the S&P 500
is trading at $3000, we would set the strike of the options at $2400.
The options account is assumed to be fully cash collateralized. Any premium is paid on the options roll date, interest is
earned on the remaining account balance, and the option payout is realized on the next roll date.
To value the options, we employ Black-Scholes pricing on an implied volatility surface derived from available out-of-the
money options. Specifically, on a given day we fit a parabola to the implied variances versus log-moneyness (i.e.
log(strike/price)) of the options for each time to maturity.
In prior research, we created straddle-derived trend-following models by purchasing S&P 500 exposure in proportion to
the delta of the strategy. To calculate delta, we had previously priced the options using 21-day realized volatility as a
proxy for implied volatility. This generally leads to over-pricing the options during crisis times and underpricing during
more tame market environments, especially for deeper out of the money puts. In this commentary we are actually
purchasing the straddles and holding them for one month.
Case #10166365
May 11th, 2020
One Month Option Implied Volatility Comparison

90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
21-day Realized Vol Vol ATM Vol 20% OTM Put Vol 20% OTM Call
Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.
Straddle vs. Trend Following

Below we plot the ratio of the equity curves for the straddle strategies versus their corresponding trend following strategies.
When the line is increasing, the straddle strategy is out-performing, and when the line is decreasing the trend strategy is
out-performing.
Case #10166365
May 11th, 2020
Ratio of Straddle Strategies to Corresponding Trend Following Strategies

2
0.5
0.25
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
3 Mo 4 Mo 5 Mo 6 Mo 7 Mo 8 Mo 9 Mo
10 Mo 11 Mo 12 Mo 13 Mo 14 Mo 15 Mo
We can see, generally, that trend following out-performed the explicit purchase of options for almost all lookback periods
for the majority of the 15-year test period.
It is only with the most recent expiration – March 20, 2020 – that many of the straddle strategies came to out-perform their
respective trend strategies. With the straddle strategy, we pay an explicit premium to help insure our position against
sudden and large intra-month price reversals. This did not occur very frequently during the 15 year history, but was very
valuable protection in March when the trend strategies were largely still long coming off markets hitting all-time-highs in late
February.
Shorter-term lookbacks fared particularly well during that month, as the trend following strategy was in a long position on
the February 2020 options expiry date, and the straddles set by the short-term lookback window were relatively cheap from
a historical perspective.
Case #10166365
May 11th, 2020
One Month Performance Differential betweeen Straddle Strategy and Trend Following (March 20,
2020)
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
3 Mo 4 Mo 5 Mo 6 Mo 7 Mo 8 Mo 9 Mo 10 Mo 11 Mo 12 Mo 13 Mo 14 Mo 15 Mo
Note the curious case of the 14-month lookback. Entering March, the S&P 500 was +45% over a 14-month lookback (almost
perfectly anchored to December 2018 lows). Therefore, the straddle was struck so deep in the money that it did not create
any protection against the market’s sudden and large drawdown.
Prior to March 2020, only the 8- and 15-month lookback window strategies had outperformed their corresponding trend
following strategies. In both cases, it was just barely and just recently.
Another interesting point to note is that longer-term straddle strategies (lookbacks greater than 9 months) shared similar
movements during many periods while shorter-term lookbacks (3-6 months) showed more dispersion over time.
Overall, many of the straddles exhibit more “crisis alpha” than their trend following counterparts. This is an explicit risk we
pay to hedge with the straddle approach and a fact we will discuss in more detail later on.
How Equity Movements Affect Straddles

Before we move into a discussion of how we can frame the straddle strategies, it will be helpful to revisit how straddles are
affected by changing equity prices and how this effect changes with different lookback windows for the strategies.
Consider the delta of a straddle versus how far away price is from the strike (normalized by volatility).
Case #10166365
May 11th, 2020
Delta Profile of Straddle versus Binary Trend Signal

1.2
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
00 70 40 10 80 50 20 90 60 0.30 0.00 0.30 0.60 0.90 1.2
0
1.5
0
1.8
0
2.1
0
2.4
0
2.7
0
3.0
0
-3 . -2 . -2 . -2 . -1 . -1 . -1 . -0 . -0 . -
Standard Deviations from Strike
Straddle Delta Trend Signal
Naively, we might consider that the longer our trend lookback window – and therefore the further back in time we set our
strike price – the further away from the strike that price has had the opportunity to move. Consider two extremes: a strike
set equal to the price of the S&P 500 10 years ago versus one set a day ago. We would expect that today’s price is much
closer to that from a day ago than 10 years ago.
Therefore, for a longer lookback horizon we might expect that there is a greater chance that the straddle is currently deeper
in the money, leading to a delta closer to +/- 1. In the case of straddles struck at index levels more recently realized, it is
more likely that price is close to at the money, leading to deltas closer to 0.
This also means that while the trend following strategy is taking a binary bet, the straddle is able to modulate exposure to
equity moves when the trend is less pronounced. For example, if a 12-month trend signal is +1%, the trend model will retain
a +1 exposure while the delta of the straddle may be closer to 0.
Case #10166365
May 11th, 2020
Delta of the Straddles for Each Lookback Window

1
0.8
0.6
0.4
0.2
-0.2
25th %ile Median 75th %ile
Additionally, when the delta of a straddle is closer to zero, its gamma is higher. Gamma reflects how quickly the straddle’s
sensitivity to changes in the underlying asset – i.e. the delta – will change. The trend strategy has no intra-month gamma,
as once the position is set it remains static until the next rebalance.
As we generally expect the straddles struck longer ago to be deeper in the money than those struck more recently, we
would also expect them to have lower gamma.
This also serves to nicely connect trend speed with the length of the lookback window. Shorter lookback windows are
associated with trend models that change signals more rapidly while longer lookback windows are slower. Given that a total
return trend signal can be thought of as the average of daily log returns, we would expect a longer lookback to react more
slowly to recent changes than a shorter lookback because the longer lookback is averaging over more data.
But if we think of it through the lens of options – that the shorter lookback is coarsely replicating the delta of a straddle struck
more recently – then the ideas of speed and gamma become linked.
Case #10166365
May 11th, 2020
Gamma of the Straddles for Each Lookback Window

16
14
12
10
0
25th %ile Median 75th %ile
The Straddle Strategy as an Insurance Policy

One of the key differences between the trend strategy and the straddle is that the straddle has features that act as insurance
against price reversals. As an example, consider a case where the trend strategy has a positive signal. To first replicate
the payoff, the straddle strategy buys an in-the-money call option. This is the first form of insurance, as the total amount
this position can lose is the premium paid for the option, while the trend strategy can lose significantly more.
The straddle strategy goes one step further, though, and would also buy a put option. So not only does it have a fixed loss
on the call if price reverses course, but it can also profit if it reverses sufficiently.
One way to model the straddle strategies, then, is as insurance policies with varying deductibles. There is an up-front
premium that is paid, and the strategy does not pay out until the deductible – the distance that the option is struck in the
money – is met.
When the deductible is high – that is, when the trend is very strong in either direction – the premium for the insurance policy
tends to be low. On the other hand, a strategy that purchases at the money straddles would be equivalent to buying
insurance with no deductible.
Case #10166365
May 11th, 2020
Insurance Characteristics of Straddle Strategies

20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Average Annual Premium Average Deductible
On average, the 3-month straddle strategy pays annual premiums of about 14% for the benefit of only having to wait for a
price reversal of 6% before protection kicks in. Toward the other end of the spectrum, the 12-month strategy has an annual
average premium of under 6% with a 16% deductible.
We can also visualize how often each straddle strategy pays higher premiums by looking at the deltas of the straddles over
time. When these values deviate significantly from +1 or -1, then the straddle is lowering its insurance deductible in favor of
paying more in premium. When the delta is nearly +1 or -1, then the straddle is buying higher deductible insurance that will
take a larger whipsaw to payout.
The charts below show the delta over time in the straddle strategies vs. the trend allocation for 3-, 6-, and 12-month lookback
windows.
There is significant overlap, especially as trends get longer. The differences in the deltas in the 3-month straddle model
highlight its tradeoff between lower deductibles and higher insurance premiums. However, this leads it to be more adaptive
at capitalizing on equity moves in the opposite direction that lead to losses in the binary trend-following model.
Case #10166365
May 11th, 2020
Deltas for 3-mo Strategies

1
0.8
0.6
0.4
0.2
-0.2
-0.4
-0.6
-0.8
-1
2005 2010 2015 2020
3-mo Trend Following 3-mo Straddle

1
0.8
0.6
0.4
0.2
-0.2
-0.4
-0.6
-0.8
-1
2005 2010 2015 2020
Case #10166365
May 11th, 2020

1
0.8
0.6
0.4
0.2
-0.2
-0.4
-0.6
-0.8
-1
2005 2010 2015 2020
Statistics on the Difference in Delta Between Straddle and Trend Strategies

0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
3-mo 6-mo 12-mo
Frequency of >0.5 Deviations in Delta Root Mean Square Delta Deviation
Case #10166365
May 11th, 2020
The chart below shows the annualized performance of the straddle strategies when they underperform trend following
(premium) and the annualized performance of the straddle strategies when they outperform trend following (payout). As the
lookback window increases, both of these figures generally decline in absolute value.
Premium vs. Payout in Straddle Strategies

50%
40%
30%
20%
10%
0%
-10%
-20%
Annualized Outperformance Annualized Underperformance
Even though we saw previously that the 3-month straddle strategy had the highest annual premium, its overall payout when
it outperforms trend following is substantial. The longer lookbacks do not provide as much of a buffer due to their higher
deductible levels, despite their lower premiums.
When the naïve trend strategy is right, it captures the full price change with no up-front premium. When it is wrong, however,
it bears the full brunt of losses.
With the straddle strategy, the cost is paid up front for the benefit to not only protect against price reversals, but even
potentially profit from them.
As a brief aside, a simpler options strategy with similar characteristics would be to buy only either a call option or put option
depending on the trend signal. This strategy would not profit from a reversion of the trend, but it would cap losses. Comparing
it to the straddle strategies highlights the cost and benefit of the added protection.
Case #10166365
May 11th, 2020
Put or Call vs. Straddles

1.3
1.25
1.2
1.15
1.1
1.05
0.95
0.9
0.85
0.8
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
3 month 12 month
Buying only puts or calls generally helped both of the strategies shown in the chart. This came in reduced premiums over a
time period when trimming premiums whenever possible paid off, especially for the 12-month lookback strategy. However,
there are some notable instances where the extra protection of the straddle was very helpful, e.g. August 2011 and late
2014 for the 3-month lookback strategy and March 2020 for both.
Despite the similarities between the options and trend strategies, this difference in when the payment is made – either up-
front in the straddle strategy or after-the fact in whipsaw in the trend following strategy – ends up being the key differentiator.
The relative performance of the strategies shows that investors mostly benefitted over the past 15 years by bearing this risk
of whipsaw and large, sudden price-reversals. However, as the final moths of data indicates, option strategies can provide
benefits that option-like strategies cannot.
Ultimately, the choice between risks is up to investor preferences, and a diversified approach that pairs strategies different
convex strategies such as trend following and options is likely most appropriate.
Conclusion
The convex payoff profile of trend following strategies naturally lends itself to comparative analysis with option strategies,
which also have a convex payoff profile. In fact, we would argue – as we have many times in the past – that trend following
strategies coarsely replicate the delta profile of option straddles.
In this commentary, we sought to make that connection more explicit by building option straddle strategies that correspond
to a naïve trend following strategies of varying lookback lengths.
Case #10166365
May 11th, 2020
While the trend following approach has no explicit up-front cost, it risks bearing the full brunt of sudden and large price
reversals. With the straddle-based approach, an investor explicitly pays an up-front premium to insure against these risks.
When evaluated through the lens of an insurance policy, the straddle strategy dynamically adjusts its associated premium
and deductible over time. When trends are strong, for example, premiums paid tend to be lower, but the cost is a higher
deductible. Conversely, when trends are flat, the premium is much higher, but the deductible is much lower.
We found that over the 2005-2020 test period, the cost of the option premiums exceeded the cost of whipsaw in the trend
strategies in almost all cases. That is, until March 2020, when a significant and sudden market reversal allowed the straddle
strategies to make up for 15 years of relative losses in a single month.
As we like to say: risk cannot be destroyed, only transformed. In this case, the trend strategy was willing to bear the risk
of large intra-month price reversals to avoid paying any up-front premium. This was a benefit to the trend investor for 15
years. And then it wasn’t.
By constructing straddle strategies, we believe that we can better measure the trade-offs of trend following versus the
explicit cost of insurance. While trend following may approximate the profile of a straddle, it sacrifices some of the intra-
month insurance qualities to avoid an up-front premium. Whether this risk trade-off is ultimately worth it depends upon
the risks an investor is willing to bear.
Case #10166365
May 11th, 2020
To read other commentaries or to subscribe to future posts, please visit blog.thinknewfound.com.
The information set forth in this document has been obtained or derived from sources believed by Newfound Research LLC (“Newfound”) to be reliable.
However, Newfound does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does
Newfound recommend that the information serve as the basis of any investment decision.
Certain information contained in this document constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology
such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations or
comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of an investment managed using any
of the investment strategies or styles described in this document may differ materially from those reflected in such forward-looking statements. The
information in this document is made available on an “as is,” without representation or warranty basis.
Backtested performance is not based on live results produced by an investor’s actual investing and trading, but was achieved by the retroactive application
of a model designed with the benefit of hindsight, and is not based on live results produced by an investor’s investment and trading, and fees, expenses,
transaction costs, commissions, penalties or taxes have not been netted from the gross performance results except as is otherwise described in this
presentation. The performance results include reinvestment of dividends, capital gains and other earnings. Backtested performance does not reflect
contemporaneous advice or record keeping by an investment adviser. Actual, live client results may have materially differed from the presented
performance results.
There can be no assurance that any investment strategy or style will achieve any level of performance, and investment results may vary substantially from
year to year or even from month to month. An investor could lose all or substantially all of his or her investment. Both the use of a single adviser and the
focus on a single investment strategy could result in the lack of diversification and consequently, higher risk. The information herein is not intended to
provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations. Any investment strategy and themes discussed
herein may be unsuitable for investors depending on their specific investment objectives and financial situation. You should consult your investment
adviser, tax, legal, accounting or other advisors about the matters discussed herein. These materials represent an assessment of the market environment
at specific points in time and are intended neither to be a guarantee of future events nor as a primary basis for investment decisions. Past performance is
not indicative of future performance and investments in equity securities do present risk of loss.
Investors should understand that while performance results may show a general rising trend at times, there is no assurance that any such trends will
continue. If such trends are broken, then investors may experience real losses. The information included in this presentation reflects the different
assumptions, views and analytical methods of Newfound as of the date of this document. The views expressed reflect the current views as of the date
hereof and neither the author nor Newfound undertakes to advice you of any changes in the views expressed herein.
This commentary has been provided solely for informational purposes and does not constitute a current or past recommendation or an offer or solicitation
of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This
commentary should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
This document does not reflect the actual performance results of any Newfound investment strategy or index.
No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission from Newfound
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© Newfound Research LLC, 2020. All rights reserved.
Case #10166365

Straddles and Trend Following: Case #10166365

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Straddles and Trend Following

May 11th, 2020

About Newfound Research

Separately Managed • Available on most major TAMP and UMA platforms

• Select Newfound strategies are made available in open-end

• Select Newfound strategies are made available in

For more information, visit www.thinknewfound.com

Methodology and Data

One Month Option Implied Volatility Comparison

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Straddle vs. Trend Following

Ratio of Straddle Strategies to Corresponding Trend Following Strategies

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

How Equity Movements Affect Straddles

Delta Profile of Straddle versus Binary Trend Signal

Straddle Delta Trend Signal

Delta of the Straddles for Each Lookback Window

25th %ile Median 75th %ile

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Gamma of the Straddles for Each Lookback Window

25th %ile Median 75th %ile

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

The Straddle Strategy as an Insurance Policy

Insurance Characteristics of Straddle Strategies

Average Annual Premium Average Deductible

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Deltas for 3-mo Strategies

3-mo Trend Following 3-mo Straddle

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Deltas for 6-mo Strategies

6-mo Trend Following 6-mo Straddle

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Deltas for 12-mo Strategies

12-mo Trend Following 12-mo Straddle

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Statistics on the Difference in Delta Between Straddle and Trend Strategies

Frequency of >0.5 Deviations in Delta Root Mean Square Delta Deviation

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Premium vs. Payout in Straddle Strategies

Annualized Outperformance Annualized Underperformance

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

Put or Call vs. Straddles

Source: Tiingo and DiscountOptionData.com. Calculations by Newfound Research.

To read other commentaries or to subscribe to future posts, please visit blog.thinknewfound.com.

© Newfound Research LLC, 2020. All rights reserved.

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