Testing TradingMarket's Rules #3&4: Don't Fight the Long-Term Trend

This is part three of this week’s series on TradingMarket.com’s (TM) 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.

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[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).

It is definitely not the smoothest of equity curves, but from a pure return standpoint, it's not bad (9.7% annualized vs 5.8% for buy and hold). Note that 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.

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[logarithmically-scaled]

And for the number lovers:

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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. However, 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.

The other articles in the series can be found here: Testing TradingMarket's 10 Trading Rules, Part 1 , Part 2 and Part 4.