basic trading system Archives - Algorithmic and Mechanical Forex Strategies

The recent evolution of ETFs as trading vehicles has expanded the available opportunities for traders and trading systems. In a recent post on his blog, Jay Kaeppel took a creative look at the good and bad aspects of international ETFs. He also put together a simple system that traded either a collection of international ETFs or the S&P 500.

Jay built a simple index of international ETFs and is using a Switch Strategy to trade them.

He starts with some of the positive and negative aspects of international stock and ETF trading:

The bad news is that picking individual stocks is never an easy thing even if you focus only on domestic U.S. companies. For the average investor to successfully pick and choose among individual stocks around the globe is simply too much to expect.
The good news is that the proliferation of international ETFs – Single country funds, regional funds, global funds, etc. – has made it much easier for investors to diversify across the globe than it used to be.
The bad news is that the proliferation of ETFs has also reached a point where choosing an international ETF is getting to be almost as confusing as choosing a phone plan.
The good news is that there are ways to simplify and systematize things.

Jay goes on to describe building what he calls the BRIC index. This is a collection of four international ETFs that represent Brazil, Russia, India, and China. His BRIC index is comprised of an equal part of the single country ETF for each of those four countries.

He then puts together a strategy that will compare the relative strength of his BRIC index to that relative strength of the S&P 500. Here is how he sums up the relative strength strategy:

I will use a method I learned a long time ago from David Vomund, President of Vomund Investment Management, LLC and the author of “ETF Strategies Revealed.”
The measure calculates the relative strength between two assets on a weekly basis.
When the trend of relative strength reverses in a particular direction for two consecutive weeks it signals a switch into the stronger index.

Jay produces thorough backtesting results for this system from 2001 through 2013. Investing half of a portfolio in his BRIC index and the other half in the S&P 500 would have returned a total profit of 189.3%. Using his switching system on the same indexes would have returned a total profit of 490%.

One obvious hole in this strategy is that the trader is still 100% long equities at all times. This means that the system would be extremely exposed to a global black swan event.

Jay doesn’t dodge this flaw, though. He makes a point to close by saying that this is not a system you should run out and start trading.

It is just an idea that appears to have an edge. It also allows traders to gain exposure to international markets without becoming an expert in them. I suggested to Jay that it would be interesting to see what would happen if he tested the same strategy using commodity or bond ETFs as well.

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.

The system buys the S&P 500 when the 10 day SMA crosses above the 100 day SMA

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.

Trading Rules

Chart and Instrument: Any

Period: 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%.

More Diversification

“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.

Increasing Risk

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.