LunaticTrader

Investing with the Moon

What a trading method can do for you – Part 2

Posted by Danny on December 9, 2015

Several readers have been asking for back test performance results of my reversal levels. I am not a fan of putting out back test results, not because the results are bad but because I don’t want to look like so many other sites that sell a poor system with good marketing. I prefer to offer a good system with poor marketing.
Also, I think it is far more important to look at forward testing rather than back testing. Back test result showing hand picked examples of great winners may be good for marketing, but it can also distort readers’ expectations and that sets them up for disappointment.
That’s why I put out a lot of weekly and daily reversal tables every morning before markets open. It allows people to verify for themselves, develop confidence in the method, get a feel for what it can and cannot do, and get realistic expectations. Profits do not come on a silver platter in the market, there is some home work to do for traders who want to succeed. Forward testing is an important part of that home work.

Back test results have several known shortcomings. We can test methods with historic data, but we don’t know if our orders would have been filled at the given prices. There is also no guarantee whatsoever that similar results will continue into the future. The structure of the market may change, possibly rendering a method useless after some time. With those shortcomings in mind I am giving back test results of weekly reversal levels for S&P 500 and Crude Oil in this post. This is for educational purposes only.

The back test simulates long only trading using the standard buy and sell signals from the weekly reversal levels. I generally avoid shorting because it is more risky and has its own specifics. And there is always a bull market somewhere. Trading is done at the weekly Close for this test. For the S&P 500 I use data from 1950, which gives us 87 trades. The list with trades is here: Reversal levels back test for S&P 500

The result:
* 44 winners and 43 losers (with one trade still open).
* The average win is 14.1% in 47 weeks, the average loss is -3.4% in 9 weeks.
* The system was in the market 68.7% of the time, giving a risk adjusted annualized return of 9.1% (versus a 7.5% rar for buy and hold S&P 500 over this period).
* The max drawdown was -31.9% (versus a max drawdown of -56.2% for buy and hold S&P 500)
* The biggest win was 77.5%. The worst loss was -9.8%

So the method succeeds in its aim to get and stay in big profitable moves while keeping losses small. The profit distribution looks like this:

profit distribution

Most of the losses (34) are smaller than 5%, only 9 losses where 5-10%. The method gives some big winners of 15% and more, which easily takes care of the small losses. All we need to do is wait for those big moves to come along and not get distracted or discouraged by the small losses. Most investors do not have that kind of patience and tend to give up just before another big move starts…

Keeping the drawdowns small is important too because it is a good measure of how much risk is being taken. Looking at the list of trades we can see that it just sits out the big bear markets and gets back in on the next buy signal. So big drawdowns are rare. This is the drawdown chart:

drawdowns

Only 4 drawdowns were bigger than 20%. A buy and hold S&P 500 strategy went through a 20% drawdown 9 times over this period.

Some readers will probably think that S&P 500 has been in a long term bull market, making it easier to have this kind of gains. What happens in a sideways market? So, I took Oil, for which I have data going back to 1984 when WTI crude traded at $31. As of today oil costs around $37, so it has been roughly flat over this period with some huge ups and downs. How did the weekly reversal levels do trading long only?
There are 48 trades, here is the list: Reversal levels back test for Crude Oil

The result:
* 21 winners and 27 losers. All trades closed.
* The average win is 15.6% in 31 weeks, the average loss is -7.4% in 10 weeks.
* The system was in the market 50.2% of the time, giving a risk adjusted annualized return of 3.6% (versus a 0.8% rar for buy and hold Oil over this period).
* The max drawdown was -63% (versus a drawdown of -74.2% for buy and hold Oil)
* The biggest win was 88.3%. The worst loss was -15.3%

So even in a sideways market the method did a good job of staying in big moves while keeping losses small. We see bigger losses and a bigger drawdown than for S&P 500, but that’s of course because oil has been more volatile. The profit distribution looks like this:

profits distribution

Most of the losses are in the 5-10% category. They are compensated for a good deal by the 5-20% winners. But the method comes out ahead thanks to picking some big winners while staying out of big losers. Two winners of around 80% and two winners of 30% make all the difference here. If we miss out on those big moves then we are not going to make the cut in a stock or commodity that is in a long term sideways range. The patience to keep trying after a string of small losses is crucial if we don’t want to miss the next big rally.

This is the drawdown chart:

drawdowns

Clearly the drawdowns are more significant here. Oil has seen huge spikes and sudden crashes over the last 30 years. It is not possible for a weekly trading method to sidestep such violent moves completely. Oil is of course a risky commodity play that should not be more than a small part of the overall portfolio. An index like the S&P 500 has diversification and that means smaller drawdowns.

I hope this gives you a better idea of what kind of results you can expect with the reversal levels. In part 3 of this series I will show how the daily reversal levels work out when you use them to trade a common stock like Apple (AAPL).

For part 1 of this article: What a trading method can do for you.

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