Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

As an individual becomes more and more involved with analyzing the financial markets, it is quite simple to be drawn deeper and deeper into more and more complex forms of analysis. Regression lines, Fourier analysis, alpha, beta, correlation coefficients, yada, yada, yada. And the truth is that there may be benefits to certain complex forms of analysis. The problem is that analysis that is more and more complex is not necessarily going to generate better investment results with each added level of complexity. It would seem as though there is a point of diminishing returns. So one of the keys to effective market analysis is to be able to understand – and explain in English – each step that you are taking in your analysis and why it will improve the overall results. Another alternative is simply to recognize that sometimes you don’t necessarily have to go to something complex. Sometimes just focusing on a simple concept can work just fine. To get an idea of what I am talking about, consider the example to follow. The idea originally came from How Markets Really Work by Laurence Connors.

A Simple Idea

What do you suppose your investment results would look like if you bought and held the S&P 500 Index (using the exchange-traded fund SPY as a proxy) for five trading days anytime the S&P 500 registered three consecutive lower closes?  In other words, if the S&P 500 closes lower on Monday, then Tuesday and then Wednesday, you would buy the S&P 500 and hold it Thursday, Friday and the following Monday, Tuesday and Wednesday (assuming there are no holidays within this timeframe).   An example of this setup appears in Chart 1.

Chart 1 – SPY register three consecutive down closes
(click here for larger view)

Sounds too simple to be useful right?  But is that in fact the case?  As always, there is only one way to find out. So let’s take a look at the results.

To test this simple idea we will start on 12/29/1987. If the S&P registers three consecutive lowers closes we will buy the S&P at the close and then hold for five trading days. If we buy after three consecutive down closes and the S&P registers another down close we will simply extend the holding period another day. Chart 2 displays the results of such a strategy.

Chart 2 – Growth of $1,000 using “3 down days” method since 12/1987

A starting investment of $1,000 on 12/29/1987 would have grown to $8,307 by 8/8/2008. This compares quite favorably to a buy-and-hold approach by which an initial $1,000 investment in 1987 would today be worth $5,300. Also, please note that the simple method I have described would have you in the market only 32% of the time. The results displayed on Chart 2 assume that we earned and annualized rate of interest of just 1%. As one might expect, this method is not without risks. During the bear market of 2000-2002, this method experienced a maximum drawdown of -19%, as you can see in Chart 3. As you can also see, there have been several other double digit percentage declines in equity along the way. Nevertheless, in most years, the maximum decline is typically no more than -6 or -7%.

Chart 3 – Percentage Drawdown of “3 Down Days” method since 12/1987

A Refinement

Is there a way to reduce the downside risk? Of course there is. However, as with most things in trading there is a tradeoff to everything. If you wanted to reduce the risk associated with the method I’ve just described, you might simply filter the longer-term trend and trade only if the longer-term trend is bullish. To accomplish this we might simply calculated a 250-day moving average of the daily closing prices for the S&P 500. Now if we get three consecutive down closes by the S&P 500, we will also look to make sure that today’s close is above the 250-day moving average.

If it is, then we will buy the S&P 500 just as we did earlier. If however, today’s S&P close is below its 250-day moving average then we will simply skip the trade. How would this have worked out?  Well, it depends on how you look at it.  

Using this filtering method, $1,000 invested in 1987 grew to only $3,174. However, on the plus side, the maximum drawdown what just –9.8% and as you can see in Chart 4, the equity curve consistently trended toward higher ground.

Chart 4 - Growth of $1,000 using “3 down days plus trend filter” method since 12/1987

Summary

So does this mean you should throw away your latest “hi tech” trading system idea and just wait for the stock market to suffer a handful of consecutive down days? Not necessarily. It does serve, however, as a reminder that it is typically best to start with a simple, logical idea. Once you have built a base there it is then safe to add on another layer of complexity.

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jay Kaeppel, Optionetics.com

• November 19, 2008
  Kaeppel's Corner: Take a Ride into the (Dis)comfort Zone
• November 12, 2008
  Kaeppel’s Corner: The Most Important Word for Investors in 2008
• November 5, 2008
  Kaeppel’s Corner: Happy Days are Here Again… No, Really
• October 29, 2008
  Kaeppel’s Corner: Volatility and Opportunity
• October 22, 2008
  Kaeppel’s Corner: When Opportunity Knocks (on the Basement Door)