Let’s take a look at a system that works almost completely opposite from the other systems we have been looking at.
This system targets small, quick profits and holds on to its losers until they revert to the mean. It also outperformed the S&P 500 by almost double from 2002-2012.
About The System
The 3 Day High/Low System is a mean reversion system. It works on the theory that if a market is in a long term trend and deviates from that trend for three straight units of time, then it is likely to revert back to the average.
In this case, we are using the 200 unit simple moving average (SMA) to define the long term trend and the 5 unit SMA to define the short term average. Using those numbers, we will assume that any market that goes three consecutive units making both lower highs and lower lows is likely to revert back to its short term average
Go Long When:
Price > 200 unit SMA
Price < 5 unit SMA
Price has made three consecutive lower lows
Price has made three consecutive lower highs
Go Short When:
Price < 200 unit SMA
Price > 5 unit SMA
Price has made three consecutive higher lows
Price has made three consecutive higher highs
Exit Long When:
Price crosses above the 5 unit SMA
Exit Short When:
Price crosses below the 5 unit SMA
The backtesting results I found for this system contained a portfolio of 20 diverse ETFs. The portfolio was limited to 10 positions at any given time. The backtest started January 1, 2002 and ran through August 1, 2012.
Over a little more than 10.5 years, this strategy posted a total net profit of 112.08%. This breaks down to an annual return of 7.36%. Over the same time period, the S&P 500 had a total return of 23.087% which breaks down to 3.984% if you reinvested the dividends.
The system recorded a total of 1389 trades, of which 73.79% were winners and 26.21% were losers. The average profit on a winning trade was 1.73% and the average loss on a losing trade was 2.69%. The average length of a trade was 4.56 bars. The winning trades averages 3.44 bars and the losing trades averaged 7.71 bars.
During the backtesting period, the largest drawdown for the portfolio was 15.19%. The largest drawdown on a single trade was 18.84%. The system posted a Sharpe Ratio of 1.60.
This system is very different from the systems I have previously covered. It has an inverse profit ratio, but is able to stay profitable because of its 73% win rate. By logging a profit on three trades for every loser, it is able to make up for those losers being almost twice as big as the winners.
Aside from drawdowns at the beginning of 2009 and at the beginning and end of 2011, the system performed fairly consistently across the ten year period.
This system goes against the common system trading goal of letting profits run and cutting losses short. It actually cuts profits short and lets losses run. Despite that, it is hard to argue with the impressive long term results. I am not sure that I would have had the guts to stick with the system when it continued to hold a position that was down over 18%.
Ideas For Improvement
Adding A Stop-Loss Component
The biggest negative with this system is that it exposes your portfolio to the possibility of establishing a position and watching it go straight to zero (or an infinite loss for a short position). While the risk of all positions crashing like that at the same time is almost zero, that non-zero risk of ruin is frightening. The most common knock against any mean reversion system is that when they eventually blow up, it can be ugly.
One way to limit this risk exposure would be to add a stop-loss component to the trading rules. More detailed backtesting could give you the information to determine the best type of stop to use.
You would want to analyze how many winning positions have drawdowns and how deep those drawdowns can be. With that information, you could experiment with ATR Stops or Bayesian Stops at different risk tolerances and backtest how they would affect the overall portfolio return.
Trading Multiple Systems
An interesting way to capitalize on the consistent returns that this system offers while reducing the risk of ruin is to trade it as a portion of a multiple system strategy. Trading this system does not mean you have to commit all of your trading capital to it, provided you have enough capital. This would give you an even greater level of diversification, but would also limit the profit potential.