This is the third part of this week’s series on TradingMarkets.com’s 10 Trading Rules. In this post, I’ll look at TM’s third and fourth rules which could be summarized as: don’t fight the long-term trend.
TM advocates a long bias when a stock is trading above its 200-day moving average and a short bias when below. This blog is about trading indices (not stocks) so I’m going to focus on how the rule applies to we index traders.
In a nutshell, I agree with TM…and I disagree.
[logarithmically-scaled]
To illustrate, the graph above shows a simple strategy I’ve shared before that uses 10-year Treasuries to trade the S&P 500 (red in the graph above, vs buy and hold in blue, from early 1962). The original strategy traded long-only, but to prove my point, the results I’ve shown above trade long and short (instead of moving to cash).
Definitely not the smoothest of equity curves, but from a pure return standpoint, not bad (9.7% annualized vs 5.8% for buy and hold). Note these results are frictionless.
Next, let’s apply TM’s rule. The graph below shows the same strategy (red) versus a new version (green) that only trades long when the S&P 500 is above its 200-day moving average and short when it’s below. In other words, we’re attempting to trade with, not against, the broader trend.
[logarithmically-scaled]
And for the number lovers:
The results above fit with my general opinion on these types of “trade with the trend” filters – they improve risk-adjusted returns and reduce drawdowns and volatility, but sacrifice some return to do it.
Very generally speaking, this is a tradeoff that traders must think about. There’s money to be made on the long side when the market is in a downtrend, and there’s money to be made on the short side when the market is in an uptrend. But that money is a lot harder to make and it’s much easier to be stunningly wrong.
In my own trading, I’ve taken different approaches to this tradeoff:
1. The State of the Market report’s “aggregate prediction” is influenced, but not limited, by the broader trend. It will buck the trend if short and intermediate-term indicators are strong enough to justify it.
2. YK is all about maximizing return in very short timeframes and trades with little consideration for the broader trend.
3. The original MarketSci strategies are long-only, and the criteria for long trades are tighter in a downtrend than in an uptrend. The net effect has generally been positive performance in up trends and flat performance in downtrends.
4. Scotty takes a similar approach as the State of the Market report. It will trade against the broader trend, but the signal has to be strong enough to justify it.
What’s the best answer? I don’t think there is one.
To use a baseball analogy, I think it depends on how you swing your bat. Base-hitters should be wary of trading against the trend. Homerun hitters might be more willing to buck it. Disclaimer: I know nothing about baseball, so if that analogy was stupid, my apologies.
[Edit: click for a summary of all related posts in this TradingMarkets series]
Happy Trading,
ms
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Filed under: Trading Strategies, Treasuries & Interest Rates | 8 Comments
I’m thinking out loud here:
Well looking at the numbers, you could use the trend trading approach with some type of leverage (probably 2x) and you would see a much higher return with the same level of drawdown to the other strategies. If you can handle a 50% drawdown, this could be another avenue to consider.
RE to Henry: very good point. This was the first thing that I applied the concept to and perhaps it wasn’t the absolute best example, cause you’re right, in this case a leveraged approach might make sense. Generally speaking though, I think this high level idea that trading with the trend slightly decreases overall return but increase risk-adjusted return plays out. Good stuff Henry. michael
Michael,
I’m a new reader to your site (which I enjoy and find very interesting btw) and I had a question for you that you probably have answered many times in the past but I’ll ask anyway. When using leverage (or perhaps even non-leverage?) why do you prefer the use of OEFs over ETFs? And as a follow up, is there a provider you prefer over another (Rydex, Direxion, Proshares etc.) and if so why? TIA.
Brad
Yes, Henry – Faber over at Worldbeta advocates a similar approach. His system uses 4 main ETFs and a 200dma to determine whether to buy or sell. This lowers return, but you can then add leverage.
The 200 MA is a very long-term indicator and is going to lag the market to great degree. If you shorten to the 50 MA you’ll see the reversals much sooner and can begin to build a position without going all in.
Michael, I would note that “Trading with the Trend” is only in the market half the time. Did the “numbers lovers” box take interest while in cash into account?
RE to Penn St: nope – see comment #2 in this thread – I think the response applies here as well. Thanks, michael
RE to Brad: thanks for the kind words. Actually, I don’t trade any of those. I trade leveraged mutual funds from Rydex, ProFunds, or Direxion. These vehicles only trade EOD and don’t allow for intraday orders.
Expect a FAQ in the near future explaining why I choose to use these because I get this question a lot, but basically it has to do with the fact that they make strategy development a lot simpler and clear cut.
Hope that helps.
michael