If you’ve ever wondered what people are talking about when they talk about a V-shaped recovery to a recession, or a V-shaped rally in markets… just take a peek at the price action in stock indices, Crude Oil, Wheat, and to a lesser extent New Zealand and Aussie Dollars. 

(Disclaimer: Past performance is not necessarily indicative of future results)
All Charts Courtesy: Finviz.com

These types of sharp reversals are kryptonite to your run of the mill systematic trading strategy which uses price momentum such as the big down moves on the left side of the “V” in all of these charts to get into new trades. From there – the trade is simple. If prices keep going down – the trade is likely to be a winner. If there is a reversal, it is likely to be a loser. But here’s some additional detail to consider – if it is a sharp reversal, the trade is likely to be a bigger than usual loser.

One of the long standing “knocks” on systematic trend following strategies is that they often give back open trade profits. But that complaint is usually framed in terms of a profitable trade, something like “you made 10% as the market had an outlier move, then ended up only making 5% as the market slowly retraced and the program waited to get out until the trend as confirmed over”.

The ‘V-shaped’ reversal brings what we call “full stop outs” into play, because of the speed at which the reversion to the mean happened. A typical systematic managed futures program may risk around 0.75% of the account equity on any one trade, yet few trades actually end up losing that much. This is because a typical trend following trade is comprised of both the risk from the entry price and the risk from the market price, meaning most models only need a small amount of time in the desired direction for the moving average of prices to come down/up, thereby reducing the amount of loss (from the entry point).

Here’s a graphical look at the risk over time (as measured from the entry price) for a fictitious trade using a basic trend following model. You can see that the greatest risk to a typical trend following type trade (the bulk of managed futures trades) is right at the outset, where the position is at risk of a sharp reversal and what we call a “full stop out”.

PS – It’s hard to talk about “V” in our office without the tech guys reminiscing about what they call one of the greatest sci-fi miniseries ever.

PPS – We prefer this shape in coffee much better:

(Disclaimer: Past performance is not necessarily indicative of future results)
All Charts Courtesy: Finviz.com