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Kaeppel's Corner: Introducing the Trading System I Invented This Morning

By Jay Kaeppel, Optionetics.com | Tue February 12, 2013 9:06AM PT

 

Alright I know it’s bad to give away the plot right at the outset, but in this case I think it is the right course of action.  For a person reading the title of this article might naturally presume that this article is about trading systems – or more specifically, one trading system in particular.

A lot of investors spend a lot of time looking for and/or trying to develop a trading system that can promise riches beyond the dreams of avarice.  But the truth is that whatever criteria you use to decide when to buy and sell, it is only a part of the overall puzzle.  In this article I will spell out the rules and calculations for one completely mechanical trading system  (that I “developed” this morning) for the stock market.  But under the surface the real point of this article is not to point out how “effective” this one particular system may or may not be.  No, the real point is nicely summed up in:

Jay’s Trading Maxim #2: In order to succeed in the markets you must have, a) A well thought out trading plan that has a realistic expectation of making money in the long run, and b) the financial and emotional wherewithal to follow your plan.   

A or b alone is not good enough.  If you have a lousy trading plan then the worst thing you can do is to actually follow it.  Likewise if you have a great trading plan but can’t quite seem to follow it, well, let’s just say that that’s not going to end well either.

Besides buy and sell signal criteria a well thought out trading plan must also involve making decisions on how much money to commit to one trade and/or all trades at one time, whether to use a stop-loss and how wide that stop-loss should be and so on.  So in this context a trading system that generates buy and sell signals is only a part of the equation. 


Trading System DuJour: JK Today

For lack of a better name – and because I came up with this system this morning - we will refer to it a JK Today.  This system is based on the time tested notion of buying a pullback in a uptrend. 


Part 1: RUT 4% Swing

This is based on a system first written about by Marty Zweig in his 1980’s classic, “Winning on Wall Street.”  In his book he used the Value Line Index.  For our purposes we will use the Russell 2000 Index (ticker RUT).

-The trend is considered “bullish” when the weekly closing price for RUT rises 4% or more from a previous weekly closing low.

-The trend remains bullish until RUT registers a weekly closing price that is 4% or more below a previous weekly closing high, at which point the trend is deemed “bearish” and remains that way until the next bullish signal.  Recent signals appear in Figure 1,

Figure 1 – RUT 4% Swing Buy and Sell Signals

As you can see in Figure 1, there is clearly no “precision market timing” involved here and whipsaws are absolutely inevitable.  Still, the purpose of this model is simply to be able to designate the overall trend of the market as “bullish” or “bearish” based on some simple, objective criteria.  And let’s face it, it doesn’t get much simpler than this.


Part 2: RYSIX/RYAIX Ratio

Ticker RYSIX tracks semiconductor stocks and ticker RYAIX tracks the Nasdaq 100 inversely.  Typically in a bull market RYSIX will advance while RYAIX declines and vice versa.  However, we will use the play between these two mutual funds to as more of a short-term overbought/oversold indicator as follows:

A = Daily close for RYSIX

B = Daily close for RYAIX

C = A / B

D = 5-day exponential average of C calculated as follows:

((previous day’s reading for D *0.667) + (Today’s C value*.333)

E = (C – D)

In English, we a redividing RYSIX by RYAIX to get a ratio each day.  Then we are calculating a moving average of that daily ratio.  Then we compare the daily ratio (C) to the moving average (D) to come up with value E.

-If the value for E was negative yesterday then tomorrow IS bullish

-If the value for E was positive yesterday then tomorrow IS NOT bullish

Just to be clear, if on Tuesday the value for E is negative, this part of the equation is bullish as of the close on Wednesday at least through the close of Thursday (If the value for E is still negative as of Wednesday’s close then this part of the equation remains bullish for Friday, but if the value for E is positive after the close on Wednesday then this part of the equation is NOT bullish on Friday).

OK, that’s as clear as mud.  Let’s try an example:

Wednesday: Value for E < 0

Thursday: Bullish as of Thursday’s close based on Wednesday’s negative value for E

Thursday: Value for E still < 0.

Friday: Bullish today based on Wednesday’s negative value for E, remain bullish at least through the close on Monday based on Thursday’s negative value for E.

Friday: Value for E is positive.

Monday: Remain bullish through the close on Monday based on Thursday’s negative value for E, but cease to be bullish as of Monday’s close based on Friday’s positive value for E.

OK, I am not sure that that helped, but for better or for worse, there you have it.

 

The JK Today System

Enter/hold a long position at the close today if:

A) The RUT 4% model is bullish

          AND

B) The RYSIX/RYAIX model Value E was < 0 after yesterday’s close

Exit a long position at the close today if:

A) The RUT 4% Model is bearish

          OR

B) The RYSIX/RYAIX model Value E was >= 0 after yesterday’s close

So simple (sort of).

 

What to Buy and Sell

Essentially any index fund or ETF will do.  Now at this point, the systems geeks out there (you know who you are), are anxious to get started back testing to see if this sucker has any real merit.  But first an important note.

Here is the part where that pesky notion of “a well thought out trading plan” rears is inconvenient head. 

First off it should be noted that this system needs be monitored on a daily basis anytime the RUT 4% Model is bullish.  And trades typically last no more than 6 days – with many trades lasting only one day. 

Do you have the time and willingness to monitor on a daily basis?  And do you possess the wherewithal to get in and out as signaled, no questions asked?

If your answer to either of these questions is “No”, then, well, your work is done here and it is time to move on to the next trading idea.

Likewise,  while “any index fund” will do, before a person could actually consider trading this system some thought needs to be given as to which index fund is most suitable.  For my purposes I am thinking of this as the type of system that a person might commit a small portion of his or her trading capital to, and as such, it might be good candidate for a leveraged index fund.  So for my purposes I will present initial results using Profunds Ultra Small-Cap fund (ticker UAPIX) which attempts to emulate the Russell 2000 index times two on a daily basis.  

Leveraged funds have a tendency to be poor choices for any method that will buy and hold for any meaningful length of time.  But because most of the trades from this system will typically last 1 to 6 days, a leveraged fund might be a good choice.

Can you stand large daily percentage swings?  If not, you should either not use a leveraged index fund and/or you should use a relatively small portion of your investment capital.


Hypothetical Results

As I just put this system together this morning needless to say there are no “real-time” results to analyze.  So we are left with hypothetical results as we ponder the potential usefulness of this method. 

-For our test we will begin on 3/20/2000 which is the day ticker UAPIX started trading. 

-We will compare the result using the system and trading ticker UAPIX when bullish and holding cash earning 1% annually when not bullish, versus buying and holding the Russell 2000 index.

Figure 2 displays the growth of $1,000 invested (hypothetically) using JK Today versus buying and holding the Russell 2000 index.

Figure 2 – Growth of $1,000 invested using UAPIX (blue line) versus buying and holding Russell 2000 Index (red line); 3/20/00-present

Figure 3 displays year-by-year results

Figure 3 – Year-by-Year hypothetical Results of JK Today System versus Buy-and-Hold

As you can see in Figures 2 and 3, during the test period – and on a completely hypothetical basis, JK Today vastly outperformed buy and hold.

 

Summary

So what have we learned?  Well, hopefully we better appreciate the concept of trading in line with the major trend.  Likewise, hopefully we also better appreciate the concept of buying short-term oversold situations within an overall bullish trend.  That is basically all that the JK Today method does.  Likewise we may also come to realize that leveraged index funds – while extremely risky and not a good choice for a buy and hold position of any length – may be extremely useful to traders who plan to hold a position no more than a handful of days.  But then again maybe not, depending on your own investment temperament.

But more than anything remember that the buy and sell signals generated by [Your favorite methodology here] are only a piece of the overall puzzle.  The best timing system in the world will ultimately do you no good if the equity swings are so great that you get gun shy and begin to second guess the signals it generates.

Lastly, if you find yourself in the next several days about to enter a position based on JK Today, well, perhaps you should stop yourself and reread the article.

Will JK Today still work tomorrow? 

As always, only time will tell.....

 

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site


Recent articles by Jay Kaeppel, Optionetics.com


July 24, 2013  -  Kaeppel's Corner: Just When You Think You Know It All....
July 15, 2013  -  Kaeppel's Corner: Beware the Market BLIP (Bernanke Linguistics Induced Panic)
July 09, 2013  -  Kaeppel's Corner: Words to Trade By
July 02, 2013  -  Kaeppel's Corner: Of Gold Stocks, Falling Safes, and Moths to Flames
June 24, 2013  -  Kaeppel's Corner: How To Enjoy Market Summer Boredom


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