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Michael Harris
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Michael Harris is a trader, book author, software program developer and blogger. He started developing advanced pattern recognition software for the benefit of position and swing traders in the late 1990s. In years past, Michael has also done work for a number of different financial firms, where... More
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Tradingpatterns.com
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Price Action Lab
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  • The Broken Dreams Of Bond ETF Investors

    The total return of an investment in (NYSEARCA:TLT) since the start of 2009 to the end of August of this year is a mere 3.31% as compared to a spectacular 98.65% total return of an investment in SPY during the same period, or a compound annual return of 0.7% for TLT versus a respectable 15.88% for SPY. Anyone who chose bonds over stocks got the short end of the stick in the mentioned period.

    (click to enlarge)

    The top pane in the above chart is a daily chart of TLT and I have inserted the total yearly returns starting in 2009 along with the total return and CAR. The bottom chart shows daily prices of SPY and I have also inserted total yearly returns so that they are easily compared to those of TLT along with the total return for said period and CAR.

    Many equity investors were compelled to sell stocks and invest in bonds after the dismal stock market performance during 2011. Specifically, during that year, TLT returned 38.2% as opposed to a 2.5% total return for SPY. Thus, many equity investors relied on past performance and not on forecasts and analysis to make investment decisions and paid dearly for such mistake because in the following two years stock returns were high while bond returns were negative.

    Having analyzed the past, something we should always remember that it is fairly easy on hindsight, the fact is that investors are now again compelled to use the past to drive their decisions and are massively moving out of bonds and into stocks, the exact opposite of what happened in 2012 after the large gains in bonds. However, bonds are not in a bear market yet, as it is shown on the TLT chart with prices above both long-term trendlines TL1 and TL2. Furthermore, even more interesting is the fact that TLT prices are above point B on the chart, used to mark the $99.29 important support level from which in 2010 started the bond decline that gave the impression at that time to some investors that bonds are entering a bear market. Actually, the decline terminated at point A, just above long-term trendline TL2 and then a spectacular rally started that generated the high returns for 2011 while stock prices corrected for that year. Is it possible that we will see a replay of this in the next 12 months or so?

    I would not be surprised after the massive moves from bonds to stocks to see a substantial decline in equity markets and a decline in bond yields. Apparently, markets are known to punish herd behavior. There is a scenario however that may not be favorable to both fixed income and equity investors in the near future and this is the possibility of stagflation, which I have mentioned in a recent SA article. Under this scenario, both bonds and stocks will correct but, in my opinion, bonds may lose less than stocks and relative performance will revert towards its longer-term average and that is a CAR of about 6.7% for TLT and 8.6% for SPY, both since inception. This is a type of a mean reversion process that usually occurs in the markets but its timing cannot be predicted in advance and, obviously, cannot be deduced from past data accurately.

    Investors can deal with the uncertainty of the interplay between bonds and stocks in the future by monitoring very close the state of the economy and specifically CPI and GDP levels. Signs of CPI increasing while GDP is falling and of GDP deflator increasing could imply stagflation. In that case a prudent strategy could be an investment in commodity funds for proper diversification. Commodity ETFs, like DBC, could serve as an alternative investment vehicle during stagflation periods because of rising prices of raw materials.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: Chart created with AmiBroker – advanced charting and technical analysis software.

    Sep 01 5:14 PM | Link | Comment!
  • Short-Term Market Correction Or A Change In Fundamentals?

    As of the close of Tuesday, June 4, 2013, the daily chart of (NYSEARCA:SPY) shows a 38.2% Fibonacci retracement of the rally from mid April to its all-time high and a support near the 30-day simple moving average. But the short-term market direction at this point in time will depend on the state of the underline fundamental conditions that fueled the rally and not on technicals. The main forces behind the rally in stock prices were persistent investor buying and the FED resolve to avert deflationary pressures. The agents behind those forces may be bluffing now for their own reasons. Longer-term investors want to add to their positions and thus they need dips and the FED does not like to reward speculators and often issues conflicting signals.

    The bluffing by investors often facilitates weak hand shakeouts and that by the FED intends to punish short-term speculators in favor of value seekers. It is impossible to know conclusively whether the underline fundamental conditions have changed although different media sources attempt to promote their own views maybe depending on their vested interests. What we can know with some satisfactory rate of success based on past market behavior are the technical conditions that are associated with the state of fundamental conditions.

    (click to enlarge)

    Scenario 1: Fundamental conditions are unchanged

    According to the RSI(14) levels shown on the bottom pane of the SPY chart, the correction will stop near or just below current levels and possibly after a 50% retracement of the rally that started in mid April. Strong support is near $159.71. Then the rally will resume.

    Scenario 2: Fundamental conditions are changing

    According to oversold RSI(14) levels reached last November the market may correct towards support near $156 and then towards the 200-day simple moving average currently near $149.40. The correction may erase a good part of YTD gains.

    In my opinion technical levels are a secondary process on top of a primary process that is determined by fundamental conditions. The relation of the primary and the secondary process is unidirectional, meaning that technical conditions very rarely determine the direction of the market but the opposite is true. Any longer-term forecasts based on technicals may be projecting cognitive biases on markets, like the notorious confirmation bias. It is quite unlikely that technical levels can forecast where the market is heading to, other than for a very short period of time in the range of a few days. It is known that long memory effects in financial price series decay after a few days and and, thus, longer-term forecasts are not justified. Any attempts to forecast the future course of markets, like weeks or months down the road, based on technicals alone may be an exercise in futility.

    Nevertheless technical analysis can be a great tool for risk management. At this point in time and based on the SPY chart above the risk of a further market correction is real (scenario 2) and thus cutting down on exposure may be a prudent move based solely on risk considerations.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: Charts created with AmiBroker – advanced charting and technical analysis software.

    Jun 05 8:45 AM | Link | Comment!
  • ETF Counter-Trend Trading Strategies

    Recently there is renewed interest in counter-trend strategies, especially for trading stock index ETFs. These strategies became popular about 5 years ago when they appeared in books and magazines. Their purported simplicity and profitability based on historical backtests have made them very attractive, especially to retail short-term and position traders of ETFs and stocks. The managed futures crowd has shown interest in such strategies recently because of the lackluster performance of trend-following models during the last few years and increasing fears that this style of trading is dead. In this article I present performance results of a portfolio of three very popular ETFs, SPY (NYSEARCA:SPY), QQQ (NASDAQ:QQQ) and IWM (NYSEARCA:IWM), for three different counter-trend trading models, and I compare them to those of a very simple trend-following model applied to the same portfolio. The results provide strong indication that the counter-trend trading models considered in this article are not as robust as the simple trend-following model and I list possible reasons for their performance degradation in recent years as compared to historical performance results before they gained popularity.

    The basic idea behind counter-trend trading

    Most known counter-trend trading systems attempt to capture profits from corrections generated by overbought markets on an uptrend, by establishing short positions, or by oversold markets on a downtrend, by establishing long positions. This is a trading method based on gambler's fallacy and the (false) notion that after a series of new highs or new lows, the probability that a correction will occur is higher. If the correction does not occur within the limits defined in the exit logic of such models, a loss is generated. Thus, it is immediately seen that for such models to perform well, the market must exhibit sufficient swings above and below the underline trend. Note, however, that buying weakness along the direction of an uptrend or selling strength along the direction of a downtrend do not amount to counter-trend trading and this fact is not always clarified by authors of such systems. This is equivalent to buying short-term dips and selling short-term tops along the underline trend. In that case, the trading models are better described as "counter-momentum" but the basic idea is the same, i.e. these models facilitate short-term position trading that is not related to trend-following.

    Portfolio backtesting results of three counter-trend strategies

    The performance of each strategy is evaluated on a portfolio of 3 popular ETFs, SPY, QQQ and IWM, in two distinct but adjacent time periods. The first period is from 01/04/2000 to 12/31/2007 and the second the period from 01/02/2008 to 11/08/2012. The former time period represents when these strategies were identified and possibly optimized. The latter plays the roll of an out-of-sample test period, i.e. a period after the strategies were already public and extensively used. The main objective of the article is to study the performance of each strategy in the two time periods and compare the results.

    The starting equity value of the portfolio of the three ETFs is $100,000. No commission or slippage are included in the tests as the intent here is to evaluate the basic idea behind counter-trend trading. Every ETF is allocated one third of the available equity when a position is opened and no multiple open positions are allowed, i.e. an open position in each ETF must be closed before another one for the particular ticker can be opened. The number of shares is calculated by dividing the allocated equity by the entry price.

    1. The double 7s strategy

    This is a long-only counter-momentum strategy defined as follows:

    1. Price is above its 200-day moving average
    2. If price closes at a 7-day low, then buy.
    3. If price closes at a 7-day high, then sell the position.

    Below is a graph of the portfolio equity from 01/04/2000 to 12/31/2007 :

    (click to enlarge)

    Below is a table of the monthly returns for the same time period:

    (click to enlarge)

    Next, is a graph of the portfolio equity from 01/02/2008 to 11/08/2012:

    (click to enlarge)

    Below is a table of the monthly returns for the same time period:

    (click to enlarge)

    A performance summary for this strategy is shown in Table 1 below:

    Parameter

    01/04/2000-12/31/2007

    01/02/2008-11/08/2012

    CAR

    7.20%

    1.31%

    Win rate

    76.35%

    69.11%

    Trades

    203

    123

    Profit factor

    2.41

    1.14

    Sharpe ratio

    1.82

    0.22

    Max. Drawdown

    -10.81%

    -15.22%

    Table 1. Performance summary for the double 7s strategy

    The degradation of the performance of the strategy after 2007 is not only evident from the equity graph and the monthly returns table but also from the sharp drop in the CAR, profit factor and Sharpe ratio values. Although during the first time period, from 01/2000 to 12/2007, there is only one down year out of 8 in total and the equity curve rises fast after 2004, in the second time period, from 01/2008 to 11/08/2012, there are 2 losing years out of 5 and the equity curves becomes erratic. These facts point to the possibility that the parameters of this system are suitable for market conditions encountered before 2008 and that the system itself is an artifact of selection bias and curve-fitting. However, there are other possibilities that are discussed at the end of this article.

    2. The double 10s strategy with 1-day exit

    This is a long/short counter-trend/momentum strategy, defined as follows:

    1. Buy at the close if price makes a 10-day low and exit the position at the close of the next day.
    2. Sell at the close if price makes a 10-day high and exit the position at the close of the next day.

    Continuation and reversal signals are allowed, in the sense that when a long or short signal is closed another long or short signal can be opened if the conditions remain in effect and short signals are initiated at a long exit bar if conditions are right and vice versa.

    Below is a graph of the portfolio equity from 01/04/2000 to 12/31/2007:

    (click to enlarge)

    Below is a table of the monthly returns for the same time period:

    (click to enlarge)

    Next is a graph of the portfolio equity from 01/02/2008 to 11/08/2012:

    (click to enlarge)

    Below is a table of the monthly returns for the same time period:

    (click to enlarge)

    A performance summary for this strategy is shown in Table 2 below:

    Parameter

    01/04/2000-12/31/2007

    01/02/2008-11/08/2012

    CAR

    8.63%

    3.01%

    Win rate

    51.03%

    47.68%

    Trades

    1742

    1034

    Profit factor

    1.23

    1.08

    Sharpe ratio

    0.74

    0.27

    Max. Drawdown

    -11.32%

    -13.28%

    Table 2. Performance summary for the double 10s strategy with 1-day exit.

    Although the equity performance in the first time period is attractive, with only one losing year out of 8 in total, in the second time period we observe degradation of performance with 2 losing years out of 5, a marginal profit factor, a very low Sharpe ratio and a much lower CAR. These observations also point to the possibility that the parameters of this system are suitable for market conditions encountered before 2008 and, although the overall return is positive after 2007, if more time is allowed the strategy may turn to a loser.

    3. The Double 10s strategy with moving average exit

    This is a long/short counter-trend/momentum strategy, defined as follows:

    1. Buy at the close if price makes a 10-day low and exit at the close when price crosses above its 10-day moving average or when a sell signal is triggered.
    2. Sell at the close if price makes a 10-day high and exit at the close when price crosses above its 10-day moving average or a buy signal is triggered.

    Continuation and reversal signals are also allowed in this case, in the sense that when a long or short signal is closed another long or short signal can be opened if the conditions remain in effect and short signals are initiated at a long exit bar if conditions are right and vice versa.

    Below is a graph of the portfolio equity from 01/04/2000 to 12/31/2007:

    (click to enlarge)

    Below is a table of the monthly returns for the same time period:

    (click to enlarge)

    Next is a graph of the portfolio equity from 01/02/2008 to 11/08/2012:

    (click to enlarge)

    Below is a table of the monthly returns for the same time period:

    (click to enlarge)

    A performance summary for this strategy is shown in Table 3 below:

    Parameter

    01/04/2000-12/31/2007

    01/02/2008-11/08/2012

    CAR

    12.16%

    3.47%

    Win rate

    65.92%

    62.61%

    Trades

    625

    353

    Profit factor

    1.59

    1.11

    Sharpe ratio

    0.87

    0.25

    Max. Drawdown

    -23.49%

    -25.98%

    Table 3. Performance summary for the double 10s strategy with moving average exit.

    Here we also have a case of excellent performance in the first time period before 2008, with only one losing year out of 8 but with high drawdown, that can be a random event, however. Also in this case, in the second time period after 2007, we observe degradation of performance with 2 losing years out of 5, a marginal profit factor, a very low Sharpe ratio and a much lower CAR. These observations also in this case point to the possibility that the parameters of this system are suitable for market conditions encountered before 2008 and although the overall return is positive after 2007, if more time is allowed the strategy may turn to a net loser.

    A simple trend-following strategy

    A simple, long-only, trend-following strategy is defined as follows:

    1. Buy when the 50-day moving average crosses above the 200-day moving average.
    2. Sell when the 50-day moving average crosses below the 200-day moving average.

    Below is a graph of the portfolio equity from 01/04/2000 to 11/08/2012:

    (click to enlarge)

    Next is a table of the monthly returns for the same time period:

    (click to enlarge)

    A performance summary for this strategy is shown in Table 4 below:

    Parameter

    01/04/2000-12/31/2007

    01/02/2008-11/08/2012

    CAR

    4.55%

    3.80%

    Win rate

    73.33%

    72.73%

    Trades

    15

    11

    Profit factor

    3.72

    2.87

    Sharpe ratio

    0.48

    0.40

    Max. Drawdown

    -13.36%

    -18.80%

    Table 4. Performance summary for the simple trend-following model

    In contrast to the three counter-trend strategies analyzed before, it may be seen that the performance parameters of this trend-following strategy have been much more stable for the two time period, as shown in Table 4. More importantly, this is a trend-following strategy with high win rate, something that goes against the widespread (false) notion that this type of strategies must have low win rate, in general. I frankly do not know where that came from but this is another example of how vague statements can become rules if repeated many times without a sanity check. The reason that many trend-following strategies have low win rate is that they are optimized. This is also the reason that most managed futures funds suffer losses, i.e. the fact that they employ optimized strategies, often involving several parameters. The more parameters available for tweaking, the smoother the equity curve obtained during the design phase but the probability for a future failure will be higher. Also, a low the win rate increases the risk of ruin and contributes highly to performance degradation.

    Discussion of the results

    In this article I analyzed the performance of three simple counter-trend strategies for ETFs that became popular about 5 years ago. I showed that since the time these strategies started enjoying widespread use, mainly by retail traders, their performance has degraded, although they are still net marginal winners. In contrast, a simple trend-following strategy has shown robust performance without the application of any advanced filters and modifications. This is expected because trend-following is supported by common sense while counter-trend/momentum trading is based on gambler's fallacy. However, in the markets, if it takes a fallacy to make money, that is good enough provided performance is robust and does not hide surprises. I am hesitant to declare the three systems analyzed in this article curve-fitted and the optimization of their parameters as the source of performance degradation. There could be some other reasons in addition. Below are three possible reasons:

    1. The strategies were curve-fitted and optimized.
    2. Reflexivity (Soros): The strategies became very popular after they were published and actually caused their own performance degradation.
    3. The strategies were random, an outcome of selection bias via some (random) process that designs strategies (including the human brain).

    I do not have an answer but I believe that in most cases a combination of the above reasons is the ultimate cause of the observed performance degradation.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: Charting and Backtesting program: Amibroker. CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.

    Apr 19 9:10 AM | Link | Comment!
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