Trend Following with Momentum Versus Moving Average: A Tale of Differences

Abstract

Despite the ever-growing interest in trend following and a series of publications in academic journals, there is still a great shortage of theoretical results on the properties of trend following rules. Our paper fills this gap by comparing and contrasting the two most popular trend following rules, the Momentum (MOM) and Moving Average (MA) rules, from a theoretical perspective. Our approach is based on the return-based formulation of trading rules and modelling the price trends by an autoregressive return process. We provide theoretical results on the similarity between various trend following rules and the forecast accuracy of trading rules. Our results show that the similarity between the MOM and MA rules is rather high and increases with increasing trend strength. However, as compared to the MOM rule, the MA rules have a more robust forecast accuracy of the future direction of price trends. As a result, under uncertain market dynamics the MA rules tend to gain an advantage over the MOM rule. Overall, the results reported in this paper help traders to understand more deeply the properties of trend following rules as well as the differences and similarities between them.

Keywords: Technical Analysis, Trend Following, Momentum, Moving Average, Return Predictability

JEL Classification: G11, G17