Testing TradingMarkets' Rule #1: Buy New Lows, Not New Highs

This week I’m going to be looking at TradingMarkets.com’s (TM) 10 Trading Rules.

While I’d usually be wary of taking trading advice from any site with that many flashing banner ads, many of the rules on TM’s list are similar in spirit to concepts I’ve talked about on this blog and very much against traditional investment thinking.

Rule #1 – Buy New Lows, Not New Highs

TM looks at two alternative strategies: (a) buying when the market reaches a 10-day high and selling when it crosses below its 10-day moving average, or (b) buying when the market reaches a 10-day low and selling when it crosses above its 10-day MA.

Below, I’ve reproduced both alternatives from 1993 (the period TM’s article covers) trading the S&P 500 index:

click to enlarge

[logarithmically-scaled]

The first strategy, buying at 10-day highs, is akin to what most individual investors do – chasing the winner until it’s not the winner anymore, and the second, buying at 10-day lows, is akin to one of the ways we approach the markets – buying where the crowd isn’t (yet).

Geek note: This is a proof of concept so these results are frictionless (no slippage or transaction costs). TM’s article assumed a trader used ETFs and intraday orders, but that’s not really what I do (I trade leveraged mutual funds), so I’ll assume an investor only bought/sold at the close. It's a slightly different approach, with the same conclusion.

And for the number-lovers:

click to enlarge

Clearly, since the early 90s taking a contrarian approach to the market (in this intermediate timeframe) has been far superior to a momentum-chasing one (which I think is a big reason why individual investors perform so poorly on average).

However, what TM doesn’t mention is that, for a good part of the market’s history, the opposite has been true. Prior to the early 80s, such a contrarian approach would have disastrous. Same test results from 1951 below:

click to enlarge

[logarithmically-scaled]

I am not invalidating TM’s rule. I wouldn’t trade the rule specifically (because I think there are much better ways to time the market in this intermediate timeframe), but I agree with it 100% in spirit. It’s a core principle behind a lot of what I do.

My point is that (like daily follow-through) this very basic characteristic of the market has evolved, and ultimately, trading strategies should be designed to adapt with it.

More to follow on this week’s TM-inspired series.

[P.S. My opinion only extends to what I call intermediate indicators. I think long-term indicators like 50/200-day moving average crossovers are a very different animal. More on this when I get to rule #3.]

The other articles in this series can be found here: Testing TradingMarket's 10 Trading Rules Part 2, Part 3 and Part 4.