…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.
