Could Trend-Following Be A Successful Trading Strategy? (Part V)

So far in this series, we’ve only explored the long-only aspect of trend following. However, since we are using derivatives anyway, there is nothing stopping us from going short as well. But should you?

The US-centric discussion around trend-following typically assumes that you go both long and short. The kicker for Indian domiciled traders is that almost all commodities are dollar denominated. There’s an implicit USDINR bet embedded in the commodities that, on average, has gone only one way: up.

Over the last decade, the Indian Rupee has depreciated by a 2.5% annualized rate. Even if the asset price doesn’t move in USD, the asset’s Rupee price drifts by that rate. Also, the USD gets a “flight to safety” bid when macro conditions worsen. You are essentially swimming against the tide by shorting dollar-denominated assets at that time. And, since current regulations do not permit hedging this currency risk, there is no way to protect yourself against these adverse moves.

There is also the less discussed matter of margin requirements during market downturns. Since down markets are generally more volatile than up markets, brokers and exchanges might increase margins to a point where you cannot take the full size of shorts that your system requires.

Aside from these risks, shorting increases your transaction costs by 2x. The short leg better make up for the increase in costs.

With all these headwinds against shorting, let’s see what happens if you add a short leg to the system we discussed in Part IV.

Post-COVID:

Pre-COVID:

It is quite apparent that the short leg needs its own system, and it need not be trend-based. It could very well be a worthwhile pursuit on its own. However, with our constraints, keeping a trend-following system long-only makes sense.

Lesson: Stay long and stay strong!