Systematic Relative Strength

Every car ad I watch seems to have a warning at the bottom of the screen: “Professional driver on closed course. Do not attempt.” Perhaps it is just our litigious society these days, or maybe knuckleheads actually try to replicate some of the stunts. When something difficult is done well by a professional, it only looks easy!

That’s pretty much the experience that Deborah Levine, a brave reporter at MarketWatch, had when she tried to trade foreign exchange on her own. The painfully honest article is entitled How I Lost $100,000 Trading Currencies: A Reporter’s Firsthand Experience. Her experience is quite typical of retail forays into the financial markets:

I opened two trial accounts, one with FXCM and the other with Forex.com, figuring that after writing about foreign-exchange markets for a while, I could put on some trades based on what I know about the markets.

The results were not pretty. Nor were they any better when she attempted to rely on “expert” opinion.

In one month of setting my own trades, I lost about $45,000.

I also tried a platform that allows individuals to piggyback on successful, professional traders. I started with $100,000 there, and split it between a few systems that seemed to be doing well. I ultimately lost $72,000 trying this.

Fortunately for Ms. Levine, the trial accounts only let you use play money. Unfortunately, lots of amateur investors go off half-cocked with real money in their 401k or personal account-and not necessarily just in forex. This process happens in every asset class, from stocks to bonds to precious metals. Amateur investors often have issues they are not fully aware of.

1) they think they know something about the market. The truth is, no one knows anything. Forecasting has not been shown to be a fruitful way to interact with the markets.

2) they do not have a disciplined plan for what to trade, when to trade, and how much to trade. All of those things need to be specified. Without a systematic process in place, you cannot do adequate testing.

3) they do not have any test results on their approach. Testing is critical. Would you like to fly in a plane that had not be tested for airworthiness?

A systematic approach utilizing relative strength does not require forecasting, specifies a transactional process precisely, and allows for long-term testing to be done. Even then, a return factor that can be shown to have a good record over the long term will go through numerous negative periods of performance. Markets aren’t easy even when you take a professional approach, but are almost sure to beat you senseless if you engage them in an amateurish way.

…by buying on the dips in the strategy returns. So says an excellent recent post from Condor Options. A strategy doesn’t necessarily work the same way as an individual security. Even if a strategy is robust, it will go through periods where it works better or worse.

…for a strategy with long-term positive expectancy, the appropriate response to a drawdown is to increase exposure – not reduce or eliminate it – on the view that the performance of the strategy will revert to its mean. Conversely, one mark of a skittish, irrational investor is that he sells after a sizable decline. Individual stock investors are notoriously driven by emotion instead of information…

In fact, some research suggests that many of the best strategies are quite volatile. It might make sense to let the volatility of the strategy work in your favor by adding to it when it is out of favor. Condor Options shows an equity curve from a simple mean reversion strategy used on the S&P 500 from 2000-2010. Investors fall into three categories:

When the equity curve of yesterday’s original strategy was below its simple moving average, “Panic” moves entirely to cash, waiting for the original strategy to rise above its moving average before stepping back in. “Frown” cuts its exposure by half when trading below the moving average, while “Think” actually commits 50% more capital whenever the original strategy is below the average.

The equity curves that are achieved are quite dissimilar. The “panic” strategy that goes to cash during the drawdowns performs terribly. Also worse than the base strategy is the “frown” strategy that cuts back exposure during drawdowns. The best results are achieved with the “think” strategy that adds exposure during the drawdowns.

Click to enlarge. Source: Condor Options

Before doing this blindly, keep in mind the requirement that the strategy needs to have a long-term positive expectancy-that means a long-term record of solid performance and a steadily rising equity curve, according to Condor. Relative strength is one of several return factors that has a long-term record of solid performance. If you look at the RS spread chart that we post weekly on this blog, you can see that RS leadership has endured a drawdown and that leaders and laggard groups have been performing similarly for a while. We see hints from the recent strong performance of our separate accounts that RS leadership may be poised to reassert itself once more. If that turns out to be the case, this could be an excellent opportunity to add to the strategy.

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Click here for disclosures. Past performance is no guarantee of future returns.