Optimal Trend-Following With Transaction Costs

Abstract

Despite trend-following investing's widespread popularity, optimal trend-following with transaction costs remains poorly understood. Existing studies on the subject are limited and use a theoretical approach that is difficult to solve. In this paper, we propose a new, more practical model that strikes a balance between theoretical simplicity and practical relevance. Our model reduces trading costs and produces a solution that is comparable to the popular simple moving average crossover rule. By using our model, traders can justify using the crossover rule in practice. We also provide historical simulations that demonstrate the effectiveness of our model, supporting our theoretical findings. In short, our paper provides a practical and effective solution to the problem of optimal trend-following with transaction costs.

Keywords: stock market, trend-following, transaction costs, simple moving average, moving average crossover

JEL Classification: G11, G17