A consistent theme running through most of my posts is that simpler is often better. With that in mind, let’s take a look at one of the simplest systems around.
About The System
The SPY 10/100 SMA Long Only System is about as basic as it gets. It was formed as my first attempt at building a trend following system. It is also one of the easiest systems to see on a chart. When the 10 unit SMA breaks above the 100 unit SMA, the system establishes a long position. It then holds that long position until the 10 unit SMA breaks below the 100 unit SMA. The system trades 1% of its account on each trade.
As you can see from the chart above, this system has been long the SPY since December. Anyone trading it would have captured the entire run that the market has been on for the past six months.
Chart and Instrument: Any
Market Condition: Trend
Go Long When:
10 Unit SMA crosses above 100 unit SMA
Exit Long When:
10 Unit SMA crosses below 100 unit SMA
System Backtesting Analysis
Over the past ten years, this system would have produced an average annual return of 5.73%. This return is slightly below the 6.58% return that could have been gained through a buy and hold approach to the SPY. While those results are disappointing, it is worth noting that the maximum drawdown for this system was only 35.81% compared to 56.47% for the SPY. Despite delivering a slightly lower return, the system did so with significantly lower risk.
The system’s average winning trade showed an 11.73% profit, while its average losing trade lost 2.84%. This is a profit ratio of over 4-1, which is exactly what we want to see from a trend following system. The system appears to do a good job of keeping losses small and letting profitable positions run.
Total winners and losers were actually better than we would expect from a trend following system. The system made 41 trades in ten years. Of those trades, 17 were winners and 24 were losers.
The combination of a strong win ratio, strong return ratio, and conservative risk management system should produce a system that performs exceptionally well. Based on these numbers, I would have expected this system to perform far better. What could we tweak to improve performance?
Ideas For Improvement
Add A Short Component
My first idea to improve the performance of this system was to add a short component. Trading in only one direction would cause the system to miss out on some of the most profitable trends when the market takes a dive. However, backtesting showed that changing the system to go short when it would have been in cash reduced the annual return to 1.42%.
“Using a single strategy on a single instrument is for people with either extreme skill or for those who simply have a death wish.” – Andreas Clenow
One of the biggest flaws with this system is that it only trades the SPY. Therefore, it is forced to only take signals from that one market and cannot take advantage of signals in any other market. Based on the win ratio and profit ratio, increasing the number of trades would increase the number of wins and the profits from those wins.
If we were to trade this system across 10 diverse markets, we might see 10 times the trade signals as opposed to trading only one market. Increasing diversification would also enable us to profit from trends in other markets while the SPY was in non-trending periods with no trade signals.
The backtesting results were based on trading a position size of 1% of the account. Going back to the win ratio and profit ratio, if we were to increase this risk to 2%, we could increase our overall return. This would also increase the maximum drawdown and overall risk of ruin.
Another idea to increase the risk would be to implement a position sizing algorithm similar to the one used in the 83/17 Breakout System. Combining this with a diversification strategy would produce a very different, but likely more robust system.
Adjusting the Moving Averages Used
Another idea to tweak this system would be to use different moving averages and see how it affects the results. Switching to a 10/50 Unit SMA system would produce more signals, but that wouldn’t necessarily mean more profit because it would also affect the win and profit ratios.
We could also adjust the opposite way, using something like the 50 and 200 unit SMAs, which would make less trades and attempt to capture more long term moves. Extensive backtesting would be required to determine the exact advantages and disadvantages of these adjustments.