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Where the Black Swans Hide: Mebane Faber Opines

Trend Following | August 19th, 2011

Mebane Faber, who was kind enough to offer positive praise for my new book Trend Commandments, takes a look at outliers here (PDF). Take a read–worth your time.

  • Michael David Rubin

    Re: Mr. Faber’s comment -
    “…in trendless markets whipsaws can occur that have negative effects on the portfolio. Second, and perhaps more important, a trendfollowing approach does not guarantee the investor from missing a black swan event in an uptrend. A very sharp move against the trend will not allow the investor or model time to react and protect against such a move. Investors looking for protection against this sort of event can use derivatives such as options to protect the portfolio when fully invested (so-called tail risk insurance), or consequently, to gain long exposure when mostly in cash and bonds (risk of missing out). This process could be a net cost (insurance) to the portfolio.”

    If one’s stop gets nailed (whipsawed), and depending how far & fast the move, isn’t it true that money management, by definition, allows for the loss to be non-fatal? And that one’s entry rules allow one to get back in quickly, either long or short?
    This has been my novice experience, per Mike’s course, and the classic literature (Market Wizards, Jesse Livermore, et al.).
    Whatever part of my lizard brain, though, that makes me wince when I lose, has also made me look into some simple option spreads to hedge that type of neurochemical event.
    Any thoughts from experienced people?

  • -wolfgang

    Michael David,

    while it is right that option strategies can protect against sharp trend breaks, one needs to consider that option strategies also cost money (as every insurance does). I have found that in the long run trend following works best if you refrain from using option strategies (if only to keep it simple). Rather use the money saved on options to add some more markets to your portfolio and increase diversification.

    Also, options are usually severely mispriced exactly when you need them most and they lend themselves poorly to backtesting.

    Whipsaws occur mostly in trendless markets and option-buying strategies cannot save you here per definition. To make money in trendless markets you would need to sell options. But if I ever saw a losing game in the long term that’s going short volatility (which option selling effectively is). You really don’t want to do that!

    The best “insurance” against whipsaws in my (practical) experience is a medium- to long-term approach or a combination of the two and broad diversification among different asset classes.

    I use equity ETFs (long or out only), commodity futures (long/short) and bond futures (long or out) in combined portfolios with a margin/equity ratio of around 25. I suffer when trends break but rarely from whipsaws. I prefer that also because when you lose money from breaking trends, this is money you already had earned (at least in the books). When you lose money from whipsaws, these losses come from your initial capital. Quite a difference.


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