A robust system is one that works well across a variety of markets (think different commodities or futures, or other assets) or under a variety of market conditions. So that means we should be able to come up with 2 or 3 robust systems and be all set, right? Even a robust system will have periods when it outperforms or underperforms its mean returns. Rather than identifying a single “one size fits all markets” system, this article looks at individual results from three basic systems as well as the results obtained when assets are divided among the three.

System performance is generally dictated by market conditions and may also be categorized by time frame. A moving average crossover system will work in upward or downward trending markets, but will suffer a series of losses in sideways trending markets. Unfortunately we can’t predict the start or end of a trending period. We can, however, incorporate systems that do not rely on.  Fortunately, option traders have a variety of strategies available to them to benefit when the markets move sideways. Even the novice option trader can incorporate covered call writing strategies on existing positions to improve performance when the markets move sideways.

The three systems discussed here include:

1. A longer-term basic trend following system for the broad market,
2. A short-term volatility based system for an individual security, and
3. A longer-term seasonal system.

The backtests use indexes so a longer period of time can be reviewed, however, well correlated exchange traded funds [ETFs] may now be used to implement the strategies.   

System 1: Long-Term Basic Trending
Basic 50 day – 200 day Exponential Moving Average [EMA] Crossover, long only, no stops

Using the S&P 500 Index (SPX), this system enters a long position when the 50-day EMA crosses up above the 200-day EMA. The position is exited when the 50-day EMA crosses down below the 200-day EMA. T-bill returns for the period are applied when not invested. SPY is a suitable ETF proxy.

System 2: Short Term Volatility (Crash System Variation – James Altucher)
Bollinger Bands and timed exit, long only, no stops.

Using Applied Materials (AMAT), enter a long position when the daily price closes below the lower Bollinger Band using a 10-day moving average and 1.5 standard deviation band setting. Exit the position at the open five days after the position is initiated.

System 3: 10-year Cycle (Variation – Larry Williams approach)
Using a higher beta index, invest during the seasonally strong periods in the 10-year cycle.

Using the Nasdaq 100 Index (NDX), invest during years ending in 3 through 5 and years ending in 7 through 0, initiating the first period on Jan 1^st (i.e. 1/1/1993) and the second period on Nov 1^st (i.e. 11/1/1997). T-bill returns for the period are applied when not invested.

Table 1 provides some basic statistics for each of the systems over a 14-year period, along with a weighted average value of all three identified as “Portfolio.” It is not a true portfolio since the strategies were not cumulative in one account with year end re-balancing. Had this been completed for the analysis, the system that has increased the most over time would have the greatest impact to the net account balance and system that has increased the least over time would have the smallest impact to it.

Table 1: System Results with an Approximate Portfolio Using All Three

The annual mean and standard deviation values for the three systems, along with the portfolio weighted average, are shown in Figures 1 and 2, respectively. Results for systems 1 & 2 are displayed as dotted lines while System 2 results use solid gray lines. This system is highlighted since it was the least stable. The darker, solid lines on each chart show the blended results.

Figure 1: System & Portfolio Annual Return Means

Figure 2: System & Portfolio Annual Return Standard Deviations

The basic strategy blending reduces the portfolio volatility. Do these approximate results completely protect the trader from black swans in trading? Not exactly—the lack of stops in any of the three systems leaves the portfolio vulnerable to sustained declines since a long position could exist in all three systems when the decline begins. However, the most volatile of the three systems actually does reduce that risk.

System 3 is the most vulnerable to crashes or sustained declines because it remains in the market for extended periods of time regardless of conditions. Although System 2 is the most volatile, its short-term nature improves the impact from sustained declines with a timed exit parameter. Rapid declines would force the trader to make a decision about continuing to use this system’s entry signals as losses accumulate across all three approaches. System 1 is the most stable in terms of 14-year returns as well as its ability to address adverse low probability moves since it will eventually prompt an exit as the 50-day EMA crosses down below the 200-day EMA.

To see the other articles by this author, please click here.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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