Optimal Trend Following Rules in Two-State Regime-Switching Models

41 Pages Posted: 18 Oct 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: September 12, 2022

Abstract

Academic research on trend-following investing has almost exclusively been focused on testing the profitability of various trading rules. However, all existing trend-following rules are ad-hoc rules whose optimality has never been justified theoretically. The goal of this paper is to fill this gap in the literature. Specifically, this paper examines the optimal trend-following rules when the returns follow a two-state process that randomly switches between bull and bear markets. We show that if the returns are modeled by a Markov switching model, it is optimal to follow the trend using the Exponential Moving Average. In a more realistic case where the returns are modeled by a semi-Markov switching model (SMSM) where the state duration times exhibit positive duration dependence, the optimal trend-following rule is somewhat similar to the Moving Average Convergence/Divergence rule. We confirm the validity of the SMSM by an empirical study that uses the data on the S\&P 500 and Dow Jones Industrial Average indices. We demonstrate that the theoretically optimal trading rule outperforms the popular 10-month Simple Moving Average and 12-month Momentum rules.

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

JEL Classification: G11, G17

Suggested Citation

Zakamulin, Valeriy and Giner, Javier, Optimal Trend Following Rules in Two-State Regime-Switching Models (September 12, 2022). Available at SSRN: https://ssrn.com/abstract=4217513 or http://dx.doi.org/10.2139/ssrn.4217513

Valeriy Zakamulin (Contact Author)

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

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Kristiansand, N-4604
Norway
+47 38141039 (Phone)

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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