One of the most important considerations for a systematic method is that it be robust—in other words, changing markets and changing parameters will not cause it to stop working. Relative strength is extremely robust, something that can be shown with Monte Carlo testing. In Michael Covel’s The Little Book of Trading, the section on trend follower David Druz has this to say:
Once a system’s algorithms and parameters are established, the system must be followed exactly and religiously. A system cannot be second-guessed or used intermittently. Values of variables cannot be altered. Parameters cannot be arbitrarily changed. A robust system works over many types of market conditions and over many timeframes. It works in German Bund futures and it works in wheat. It works when tested over 1950•1960 or over 1990•2000. Robust systems tend to be designed around successful trading tactics not designed around specific types of markets or market action. And here is the amazing thing about robust systems: The more robust a system, the more volatile it tends to be! Druz gives this advice: “There are whole families of trend trading ideas that seem to work forever on any market. The down side is they are very volatile because they are never curve-fit. They’re never exactly fit to any particular market or market condition. But over the long run, they do extract money from the market. You want to be focused on how you divvied up the risk in your portfolio, how much risk you take in each market, how many contracts you trade in each market, that’s the stuff that really counts…if you have money management wired, you can let volatility go because you know it doesn’t have any correlation with the risk of ruin. You can use volatility to your advantage.”
Druz’s points are well-taken. A robust system works over many timeframes and can adapt to a lot of market conditions. However, because they are not optimized, they tend to be volatile. We see this especially during periods when markets are relatively trendless or are in the midst of a changing trend. There is always some specific method that is optimized and perfectly adapted to the current market—but as soon as the market character changes, it may fail miserably.
With a robust system, you are accepting a different trade-off. It will probably never work perfectly in any market environment, but it will probably work pretty well in a wide range of conditions. That’s a pretty good description of how relative strength works. It goes through rough stretches but generally manages to adapt enough over time to deliver good long-term performance. The trick for investors is to sit on their hands during the rough stretches—a truism for any long-term winning method, whether relative strength or value.
[...] What makes for a robust system? (Systematic Relative Strength) [...]