Optimal Trend-Following in a Markov Switching Model

12 Pages Posted: 2 May 2022

See all articles by Valeriy Zakamulin

Valeriy Zakamulin

University of Agder - School of Business and Law

Javier Giner

University of La Laguna - Faculty of Economics, Business and Tourism

Date Written: April 25, 2022

Abstract

This paper assumes that the market returns follow a two-state Markov process that randomly switches between bull and bear states. We show that in this case, the exponential moving average (EMA) represents the optimal trend-following rule. The paper provides the analytical solution to the optimal window size (decay constant) in the EMA rule. We estimate the optimal window size for timing the S&P 500 stock market index using real-world data. A comparative statics analysis finds that the optimal window size depends mainly on the signal-to-noise ratio of returns and the state transition probabilities.

Keywords: Markov switching model, bull-bear markets, optimal trend-following, moving averages

JEL Classification: G11, G17

Suggested Citation

Zakamulin, Valeriy and Giner, Javier, Optimal Trend-Following in a Markov Switching Model (April 25, 2022). Available at SSRN: https://ssrn.com/abstract=4092437 or http://dx.doi.org/10.2139/ssrn.4092437

Valeriy Zakamulin (Contact Author)

University of Agder - School of Business and Law ( email )

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HOME PAGE: http://vzakamulin.weebly.com/

Javier Giner

University of La Laguna - Faculty of Economics, Business and Tourism ( email )

Camino La Hornera s/n
La Laguna, Tenerife, 38071
Spain
+34 922317102 (Phone)

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