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.

 

Mulvaney Capital – a fund with a “lumpy” history of returns, but one that can be highly rewarding in certain market environments, particularly in sharp downturns – click to enlarge.

 

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.

 

Short trigger after breaking the low of the set-up candle – click to enlarge.

 

Back-Testing Setups

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.

 

The regression line indicates a mild positive tendency on day one after a double bottom – click to enlarge.

 

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).

 

Returns on day two have a negative tendency, partly reversing the result of day one – click to enlarge.

 

On Day 3 we have a weak positive correlation, so the market is trying to rise again.

 

A very weak positive correlation is evident on day three – click to enlarge.

 

Conclusion

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

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

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: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • America Goes Full Imbecile
      Credit has a wicked way of magnifying a person’s defects.  Even the most cautious man, with unlimited credit, can make mistakes that in retrospect seem absurd.  But an average man, with unlimited credit, is preeminently disposed to going full imbecile.   Let us not forget about this important skill...  [PT]   Several weeks ago we came across a woeful tale of Mike Meru.  Somehow, this special fellow, while of apparent sound mine and worthy intent, racked up...
  • Retail Capitulation – Precious Metals Supply and Demand
      Small Crowds, Shrinking Premiums The prices of gold and silver rose five bucks and 37 cents respectively last week. Is this the blast off to da moon for the silver rocket of halcyon days, in other words 2010-2011?   Various gold bars. Coin and bar premiums have been shrinking steadily (as have coin sales of the US Mint by the way), a sign that retail investors have lost interest in gold. There are even more signs of this actually, and this loss of interest stands in stark...
  • Credit Spreads: Polly is Twitching Again - in Europe
      Junk Bond Spread Breakout The famous dead parrot is coming back to life... in an unexpected place. With its QE operations, which included inter alia corporate bonds, the ECB has managed to suppress credit spreads in Europe to truly ludicrous levels. From there, the effect propagated through arbitrage to other developed markets. And yes, this does “support the economy” - mainly by triggering an avalanche of capital malinvestment and creating the associated boom conditions, while...
  • Gold Divergences Emerge
      Bad Hair Day Produces Positive Divergences On Friday the ongoing trade dispute between the US and China was apparently escalated by a notch to the next level, at least verbally. The Trump administration announced a list of tariffs that are supposed to come into force in three week's time and China clicked back by announcing retaliatory action. In effect, the US government said: take that China, we will now really hurt our own consumers!  - and China's mandarins replied: just you wait, we...
  • Industrial Commodities vs. Gold - Precious Metals Supply and Demand
      Oil is Different Last week, we showed a graph of rising open interest in crude oil futures. From this, we inferred — incorrectly as it turns out — that the basis must be rising. Why else, we asked, would market makers carry more and more oil?   Crude oil acts differently from gold – and so do all other industrial commodities. What makes them different is that the supply of industrial commodities held in storage as a rule suffices to satisfy industrial demand only for a...
  • Chasing the Wind
      Futility with Purpose Plebeians generally ignore the tact of their economic central planners.  They care more that their meatloaf is hot and their suds are cold, than about any plans being hatched in the capital city.  Nonetheless, the central planners know an angry mob, with torches and pitchforks, are only a few empty bellies away.  Hence, they must always stay on point.   Watch for those pitchfork bearers – they can get real nasty and then heads often roll quite literally....
  • Lift-Off Not (Yet) - Precious Metals Supply and Demand
      Wrong-Way Event Last week we said something that turned out to be prescient:   This is not an environment for a Lift Off Event.   An unfortunate technical mishap interrupted the latest moon-flight of the gold rocket. Fear not true believers, a few positive tracks were left behind. [PT]   The price of gold didn’t move much Mon-Thu last week, though the price of silver did seem to be blasting off. Then on Friday, it reversed hard. We will provide a forensic...
  • Merger Mania and the Kings of Debt
      Another Early Warning Siren Goes Off Our friend Jonathan Tepper of research house Variant Perception (check out their blog to see some of their excellent work) recently pointed out to us that the volume of mergers and acquisitions has increased rather noticeably lately. Some color on this was provided in an article published by Reuters in late May, “Global M&A hits record $2 trillion in the year to date”, which inter alia contained the following chart illustrating the...
  • Cryptocurrency Technicals – Navigating the Bear Market
      A Purely Technical Market Long time readers may recall that we regard Bitcoin and other liquid big cap cryptocurrencies as secondary media of exchange from a monetary theory perspective for the time being. The wave of speculative demand that has propelled them to astonishing heights was triggered by market participants realizing that they have the potential to become money. The process of achieving more widespread adoption of these currencies as a means of payment and establishing...
  • The Fed's “Inflation Target” is Impoverishing American Workers
      Redefined Terms and Absurd Targets At one time, the Federal Reserve's sole mandate was to maintain stable prices and to “fight inflation.”  To the Fed, the financial press, and most everyone else “inflation” means rising prices instead of its original and true definition as an increase in the money supply.  Rising prices are a consequence – a very painful consequence – of money printing.   Fed Chair Jerome Powell apparently does not see the pernicious effects...

Support Acting Man

Item Guides

j9TJzzN

The Review Insider

Dog Blow

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com