Lumpy but Robust
[ed note: this article has originally appeared at the Evil Speculator and was written by trader and ES contributor Scott. We provide a link to Scott’s past articles below this post for readers who want to get more familiar with his ideas and/or any unusual terminology used in this article]
One continual theme in my trading is that every time I think I have it figured out, I get punched in the face by an unexpected problem. The tendency is to go more complicated, but often the solution is a degree of acceptance with respect to the nature of the game. Sometimes my edges work, sometimes they don’t. Sometimes they stop working for long periods of six months or more.
Financial markets – multi-layered like onions
That’s actually fine for me, but it isn’t for many other people. The systems one ultimate chooses have to suit one’s personality. If one cannot handle extended periods of working hard without making money (I can) one has to retool one’s trading systems to avoid such situations.
My opinion is that the best edges are robust. Robust edges tend not to disappear, but don’t post objectively high results either (in terms of SQN, Sharpe or expectancy). I’m investing in a fund that generates the returns (after fees) shown below, by using a very simple and standard approach to trend following, not much different from very similar methods employed by numerous other firms.
The fund is clearly an amazing investment, but its returns are lumpy; e.g. it generated a 108% return in 2008, but had a few negative years as well. Its Sharpe ratio is only around 0.7, not exactly institutional grade for most people. But its edge is robust, demonstrably provable, the system is simple and I understand it.
It is almost inconceivable that 20 years from now (the time frame I intend to keep this investment) I will be looking at an empty account saying “I wonder why trend following stopped working”. If the dreams of the bears come true, the odds are very strong that this fund will post another triple digit year. This is the gold standard of a robust edge for me.
Looking for an Edge
My opinion is that simplicity is sophistication, and complexity is laziness. The first thing one needs to figure out before going any further is: Does a system have an edge? Use a scatter plot to figure that out. If you don’t want to do that, pick the classic edges used by other professionals and you won’t go too far wrong.
At Evil Speculator, user Francis (Mulv) has gone out of his way to provide some excellent statistics. What he discovered is a classic property of mean reversion systems, which segues into a classic mistake often made in back-testing. That problem is selection bias; if e.g. a random entry is selected and tested on a market one knows has gone up, it will probably show an edge.
One can avoid this tendency to deceive oneself by testing random markets (and keeping the results hidden so one cannot trick oneself). Professionals refer to this as “out of sample data”. Another method is to sequester part of the available data and keeping it aside, and then test one’s data against it to see if one’s hypothesis matches clean data.
One thing we know for sure is that mean reversion works dramatically better in the direction of the higher time frame trend. So if this works as a short setup in the current stock market, it should work even better as a long setup (or something is very wrong). Let’s delve deeper into this and take a look at the bounty Francis has provided.
I haven’t had the time to personally verify the statistics, but at a glance they look right. Take it for what it is, an interesting exercise you can apply to your own potential setups, rather than an authoritative data set. Also, there is a significant chance that I have misinterpreted the data, since it isn’t my own spreadsheet I’m working with. If so, mea culpa, but it remains a valuable exercise to learn from.
Detailed instructions on how to do this can be found by clicking here (read the bit about adding regression lines). I will break down the results below. First off, Francis has tested with and without the condition “break of the low of the setup bar”, so we can take a look at how much, if at all, it changes things.
The reason we want to test first without the break of the low/high and then with the break, is that we can test everything one at a time this way. If the setup works with a break of the low, the effect may possibly only be due to the break. That is the kind of thing we want to find out.
At this stage I will only look at long setups. In a bull market the short side is categorically not an edge (not surprisingly, shorting the e-mini has been a good way to get one’s face ripped off over the last 7 years). The bottom line is that one has to take all these results with a grain of salt, since it is a strong market.
First let us look at what the market does on the day after making a double bottom (without breaking the high). You can see below that there is a decent positive correlation, the points are reasonably clustered (i.e., the R squared value is OK). This tells us what we would usually expect, namely that the market is trying to go up after making a double bottom.
Things that would be worth testing in this context would be buying the close and selling the following close, or alternatively buying the old spike low on a limit and selling the following close.
Day 2, however, is showing that the results of the first day are just a blip – the market is now negatively correlated. That is not what one would want to see, but perhaps there is a retest of the low (that’s drawing a very long bow).
On Day 3 we have a weak positive correlation, so the market is trying to rise again.
So what do we have here? We have a market with a very weak tendency to rise on days one and three after making a double bottom. This is not at all what we would expect from a strong edge. Aside from the result obtained on day one it actually isn’t an edge at all.
When we move on we will look at how it behaves with a break of the lows/highs as part of the conditions. Next we will consider it as a component of mean reversion, at Bollinger bands, Keltner bands and 50-bar highs/lows. The logic behind this is that a reversal setup is likely to work better at extremes.
For now we have to conclude that there is nothing inherently bullish about a short term double bottom in ES beyond producing an intraday bounce, which is actually great to know.
To be continued.
Here is a link to Scott’s previous articles at Evil Speculator for readers interested in learning more about the systematic approach discussed above and other strategies Scott has written about.
Charts by Mulvaney Capital Management, Scott/ Evil Speculator
Chart and image captions by PT, as well as light editing of the original article
You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- Speculative Blow-Offs in Stock Markets – Part 1
Defying Expectations Why is the stock market seemingly so utterly oblivious to the potential dangers and in some respects quite obvious fundamental problems the global economy faces? Why in particular does this happen at a time when valuations are already extremely stretched? Questions along these lines are raised increasingly often by our correspondents lately. One could be smug about it and say “it's all technical”, but there is more to it than that. It may not be rocket science, but...
- Speculative Blow-Offs in Stock Markets – Part 2
Blow-Off Pattern Recognition As noted in Part 1, historically, blow-patterns in stock markets share many characteristics. One of them is a shifting monetary backdrop, which becomes more hostile just as prices begin to rise at an accelerated pace, the other is the psychological backdrop to the move, which entails growing pressure on the remaining skeptics and helps investors to rationalize their exposure to overvalued markets. In addition to this, the chart patterns of stock indexes...
- India: Still the Fastest Growing Large Economy?
India’s Currency Ban - Part X It has now been four months since Narendra Modi declared about 86% of monetary value of currency illegal. Linked here is the last in my series of updates, which was written soon after the deadline to deposit the demonetized currency. Most of the banned currency was eventually deposited, making a mockery of Modi, who had claimed that unaccounted money would not reach the banks. Perhaps 3% of the cash never reached the banks. A cunning plan...
- Gold Sector: Positioning and Sentiment
A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
- They're Worried You Might Buy Bitcoin or Gold - Precious Metals Supply and Demand
Bitcoin Mania The price of gold has been rising, but perhaps not enough to suit the hot money. Meanwhile, the price of Bitcoin has shot up even faster. From $412, one year ago, to $1290 on Friday, it has gained over 200% (and, unlike gold, we can say that Bitcoin went up — it’s a speculative asset that goes up and down with no particular limit). Bitcoins are a lot less tangible than this picture implies, but they are getting a lot of love recently...
- Welcome to Totalitarian America, President Trump!
Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed. Image adapted from the cover of “Deep State #5” - depicting an assassin from the future President Trump joins the very crowded list of opponents of the American...
- The Long Run Economics of Debt Based Stimulus
Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century. Gross domestic product (GDP) has moderated onward while government debt has spiked upward. Orthodox economists continue to be flummoxed by what has transpired. What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity. Although the fat lady has so far only...
- Boosting Stock Market Returns With A Simple Trick
Systematic Trading Based on Statistics Trading methods based on statistics represent an unusual approach for many investors. Evaluation of a security's fundamental merits is not of concern, even though it can of course be done additionally. Rather, the only important criterion consists of typical price patterns determined by statistical examination of past trends. Fundamental considerations such as the valuation of stocks are not really relevant to the statistics-based trading...
- Searching for Truth
Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth? Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
- Why the 21st Century Sucks - Turtles All the Way Down
A Truly Sucky Century BALTIMORE – What an awful century! Worst we’ve ever seen. Household incomes are down. Employment is down, with 7 million people in the U.S. of working age without jobs. Productivity growth is down. GDP growth is down – to only about 0.5% per capita last year. Even life expectancies are down. Drug overdoses are up. Suicides are up. One out of every eight children lives in a family getting food stamps. One of out every eight adults takes psychoactive drugs...
- Gold and the Fed's Looming Rate Hike in March
Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
- India: The next Pakistan?
India’s Rapid Degradation This is Part XI of a series of articles (the most recent of which is linked here) in which I have provided regular updates on what started as the demonetization of 86% of India's currency. The story of demonetization and the ensuing developments were merely a vehicle for me to explore Indian institutions, culture and society. The Modimobile is making the rounds amid a flower shower. [PT] Photo credit: PTI Photo Tribal cultures face...