Testing TradingMarket's Rule #9: Avoid Being Churned with ADX

This is the last part of this week’s series on TradingMarkets.com’s 10 Trading Rules. In this post, I’ll look at TM’s rule #9: use the ADX indicator to avoid getting churned.

TM advocates not trading the market when the 10-day ADX is below 20 because in their words “it’s very difficult to make money in a trend-less market.” Unfamiliar with the ADX? Basically, it’s designed to measure the strength (high ADX) or weakness (low ADX) of a trend. Click for the obfuscated formula.

Up to this point, I’ve agreed in spirit with almost everything on TM’s list, but this one, I just don’t get. This post will be a little like disproving that all swans are white. I’ll simply produce a couple of simple, straightforward black ones.

Swan #1: 50/200-day Crossovers

click to enlarge

[logarithmically-scaled]

The graph above shows the results of a simple 50/200-day moving average crossover strategy applied with (red) and without (green) TM’s ADX rule to the S&P 500 index (blue) from 03/1993.

Geek notes: The ADX requires intraday data to calculate, so I’ve used the ETF SPY to calculate the ADX (which is why this test is so short) but the index for calculating the moving averages. This is a proof of concept, so this test is frictionless (ignores transaction costs and slippage) and does not account for return on cash.

And for the number lovers:

click to enlarge

Although this is a very short test for such a long-term strategy, clearly the ADX rule added no value over the last 16 years. This is a particularly strong death knell because this is a trend-following system and by the nature of TM’s argument, the ADX indicator should have been the most effective.

Swan #2: the RH Strategy

click to enlarge

[logarithmically-scaled, monthly-interval]

Looking at a real-world example, in the graph above I’ve taken the independently-audited real-time results for the RH S&P 500 Strategy (red) since inception and looked at how it would have performed had it used TM’s ADX rule (green).

click to enlarge

While I think you could try to argue that the ADX rule removed a portion of time when the strategy didn’t do much, I don’t think you could argue that the rule improved the strategy in any significant way.

Closing Thoughts…

As I mentioned at the beginning of the post, I’ve agreed in spirit with almost all of TM’s rules that I’ve tested up to this point, but I think this one is a dud.

Perhaps it’s applicable in some specific instances, but generally speaking, the ADX in the form used here, does not play particularly good defense.

[Edit: click for a summary of all related posts in this TradingMarkets series]

[Geek note: It is important to note that if attempting to reproduce these results, there are multiple slightly different ways of calculating the ADX (mainly due to the non-traditional way in which Wilder originally designed it). I have used the method outlined in the link provided in the post.]

The other articles in this series can be found here: Part 1, Part 2 , Part 3 and Part 4.

Comments

[John Lounsbury:]

It is interesting that for the strategy (red, no filter), there is significant underperformance during the two market topping periods. This might be worth looking at to see if marking topping indicatiors could avoid using the strategy just during those times.

Jan 11 01:07 PM

[Urbane Gori...:]

Check out Dr. Schaap's webpage for his handling of the ADX and DMI. It's very simple and extremely clear. He and his wife also have a free emailed blog with examples and do sell three books/CD. They do not sell an advisory service. In fact, Schaaps latest book which details his 50-50 approach is probably the best book a beginning investor can buy as it not only lays out how to enter and exit stocks, but how to determine quickly whether or not a company is a solid investment. It also explains what moves the market.

jegan ;-)

Jan 11 06:12 PM

[User 377992:]

If you think about it, what is the point of using the ADX as a filter? As John above points out, it keeps you out of non-trending markets; it doesn't necessarily make you more money IN THIS INSTRUMENT/MARKET. But, it does free your money to be put elsewhere, so it would be difficult to quantify it, but what you'd have to do is add in profits you would've made elsewhere during the times that the ADX kept you out of the S&P. That would be a fair analysis.

Mar 17 01:56 PM