Trading the Odds

A statistical approach to profit in the US equity markets, trading the markets like professional card counters are playing Blackjack or expert poker players are playing Poker.

The Market Shows it Pays to be a Contrarian

The Market Shows it Pays to be a Contrarian

There are some often cited adages amongst investing commentators and traders, e.g. “Don’t try to catch a falling knife”, “The trend is your friend.”, “Nobody rings a bell at the market bottom.”, “Buy on strength” and “Sell into weakness” (the trend following approach), among others. But due to the fact that I’m one of those contrarians who see opportunity where others fear “disaster” (and vice versa), and being a ‘scientific sceptic’ (who regularly questions the reliability of those adages) I’m always eager to check if and to what extend those adages might prove true in the current (and past) investment cycle, and how to capitalize on any observations made during my investigations. To make a long story short: The current investment cycle  requires to -at least- question some adages and/or shows opportunity to add some fresh adages to the already long list.

Due to the recently often discussed short-term mean-reversion character of the markets, and in order to check if there is a way to increase the quality of forecast for the respective next session’s outcome (probabilities for a higher/lower open, higher high, lower low and/or higher/lower close), I took a deeper dive into the (trend following) “Buy on strength” and “Sell into weakness” adages.

For the time frame since 10/01/2007 (approximately the beginning of the current bear market), I checked for the SPY‘s outcome of the respective next session after the following setups had been triggered:

  • at-any-time: Buy on close on every session regardless of any setup (no questions asked), sell on close the next session
  • Survey I: SPY posted a higher high above the previous session’s high (as a proxy for intraday strength)
  • Survey II: SPY posted a lower low below the previous session’s low (as a proxy for intraday weakness)
  • Survey III: SPY DID NOT post a higher high above the previous session’s high (limited upside potential, as a proxy for some intraday weakness)
  • Survey IV: SPY DID NOT post a lower low below the previous session’s low (limited downside potential, as a proxy for some intraday strength)

The following table shows -over the course of all 382 sessions since 10/01/2007- the SPY‘ behavior and the respective performance on those sessions immediately following the session when the respective setup was triggered. Odds (potential payout and expectancy, NOT the true chances that the event will occur) significantly above or significantly below their respective at-any-time odds (in this case +/-20.00%, but this percentage is up to everyone’s decision what may be regarded as ’significant above’ or ‘below’) are marked by a green (for a probable bullish or favorable outcome) and red (for a probable bearish or unfavorable outcome) background color. This should make it possible to catch on a glimpse if (any), where (e.g. EOD end-of-day change compared to the previous session’s close, or C-O close minus open for intraday strength/weakness) and to what extent (compared to historical odds) the respective setup out- or underperformed the market and if any tradable edge is provided.

survey-20090408-12

(click on image to enlarge)

First impressions:

  1. Survey (Setup) I -SPY posted a higher high than the previous session’s high- provides an unfavorable setup (concerning a bullish bias) due to the fact that the average profit on winning trades (+0.61%) is lower, and the average loss on loosing trades (-0.91%) is higher than the respective averaged at-any-time profits (+0,75%) and losses (-0,88%). In addition the profit factor of 0.66 (+104.85%/158,19%) is far worse than the even worse (because lower than 1) at-any-time profit factor of 0.85 (+285%/336,58%).
  2. Survey (Setup) II -SPY posted a lower low than the previous session’s low- seems to provide a highly favorable setup (concerning a bullish bias) due to the fact that the average profit on winning trades (+0.90%) is higher, and the average loss on loosing trades (-0.78%) lower than the respective averaged at-any-time profits (+0,75%) and losses (-0,88%). In addition the profit factor of 1.15 (+185.99%/161,30%) is significantly higher than the respective at-any-time profit factor of 0.85 (+285%/336,58%). Concerning a potential mechanical trading system -buy the SPY on open, sell on close on a session following those sessions on which setup II had been triggered-  survey II would outperform a respective at-any-time trading system as well, means on average the market closed above it’s open more often and to a greater extent after setup II had been triggered than on an at-any-time session.
  3. Survey (Setup) III -SPY DID NOT post a higher high than the previous session’s high- seems to provide a neutral setup in comparison to the respective at-any-time performance figures because it did neither out- nor underperform the market to any significant extent.
  4. Survey (Setup) IV -SPY DID NOT post a lower low than the previous session’s low- seems to provide a highly unfavorable setup (concerning a bullish bias) -to say the least- due to the fact that the average profit on winning trades (+0.57%) is significantly lower, and the average loss on loosing trades (-0.99%) higher than the respective averaged at-any-time profits (+0,75%) and losses (-0,88%). In addition the profit factor of 0.57 (+99.17%/173,94%) is far worse than the even worse (because lower than 1) at-any-time profit factor of 0.85 (+285%/336,58%). The same applies accordingly concerning intraday trades following a potential mechanical trading system -buy the SPY on open, sell on close on those sessions following those sessions on which setup IV had been triggered-.

But how to capitalize on those observations ? A logical next step would be to simply capitalize on favorable and unfavorable (from a bullish perspective) setups by taking long trades only (on close of the day when the respective setup was triggered) concerning setup II -SPY posted a lower low than the previous session’s low-, and going short (in order to turn an unfavorable bullish setup into a favorable bearish setup) on close of those session when setup I -SPY posted a higher high than the previous session’s high- OR setup IV -SPY DID NOT post a lower low than the previous session’s low- were triggered.

SurveyALL: “Buy the SPY on close of those sessions when the SPY had posted a lower low than the previous session’s low, and go short the SPY on close of those sessions when the SPY had posted a higher high than the previous session’s high OR the SPY had NOT posted a lower low than the previous session’s low; if both a long and a short signal had been triggered on the same day, take the buy signal only ; close the trade on close of the next session and enter into a new one.” (the last condition wouldn’t make sense in a real trading system, if no controversinal signal would be triggered you’d still hold on to your position) That is more or less the equivalent of  “Buy on weakness and sell on strength.” and contradicts the respective trend-following adage.

The following table shows -over the course of all 382 sessions since 10/01/2007 again- the SPY‘ behavior and the respective performance on those sessions immediately following the session when the respective setup was triggered, now including SurveyALL in the last column and reflecting the potential performance figures of a combined trading system (Survey I up to IV are unchanged).

survey-20090408-11

(click on image to enlarge)

Bottom line:

  1. A mechanical trading system following SurveyALL would have had (almost) always been in the market, there were only 2 sessions out of 382 when the setup would NOT had been triggered (05/22/2008 and 12/18/2008).
  2. The system would have yielded a return of investment (not accounting for commissions, fees and slippage; not leveraged and not compounded) of 359.93%-260,47%=+99.47% compared to an at-any-time ROI of -51.42% (a ‘buy and hold’ approach would have yielded -47.08% since 10/01/2007, means the SPY has lost -47.08% during that time frame).


survey-20090408-142

(click on image to enlarge)

Not bad for a pretty easy mechanical trading system with 197 winning trades and 184 loosing trades (but unfortunately with hindsight bias only), which from a win/loss ratio’s perspective only, would be nothing to write home about (but in this case not the probability of being right or wrong but the odds count). Up to now I haven’t calculated other important figures like max. drawdown and shape ratio.

So a new adage with respect to the current investment cycle might be: “If the market did not make a lower low today – it probably will tomorrow.” or “If the market posted a higher high today – it will probably post a lower low tomorrow.” (and therefore “Buy on strength” as well as “Sell on weakness” might not represent favorable guidelines at least for today’s markets)

But please keep in mind: These statistics are provided for informational and statistical purposes only, and there would be still a lot more work to do in order to check if this combined setup could be converted into a profitable trading system (e.g. if it would be profitable and to what extent in other times frames and markets as well).

Successful trading,

Frank

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Filed under: Studies/Survey, Trading Strategies

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  • VRP STRATEGY on Fri., 10/31/2014 (preliminary estimate): Long $XIV closed out, switch to long $VXX (market-on-close). tradingtheodds.com/portfolio/ 6 hours ago
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The information on this site is provided for statistical and informational purposes only. Nothing herein should be interpreted or regarded as personalized investment advice or to state or imply that past results are an indication of future performance. Under no circumstances does this information represent an advice or recommendation to buy, sell or hold any security.

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