Relatively Speaking !!

I just finished reading this book called Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell by Charles D. Kirkpatrick. This book has resonated with me quite a bit. Needless to say, I highly recommend it.

The book presents the authors research where is looks at the market in relation to itself and introduces the concept of relatives. The author compares the performance of the stock in relation to the other stocks in the market and ranks them in percentiles. He then 'backtests' and claims that the 'market leaders' continue to lead the market in the short term and yield better than the market.

Sounds good to me. It is a simple idea that makes sense.

What is a good strategy ?

In my last post, I showed a very simple strategy. Of course it does not work in the real world. It exposes too much of your capital to risk... capital that is better used elsewhere.

So, that leads to me to the question of this post. What is a good strategy. The strategy in the last post was profitable.  Over a span of 5years, it yielded 11%. On an annualized basis, its gave 2.21 % per year. It is definitely not fantastic, but is better than your bank.

Notice that the win rate for that strategy was 40.48 %. I could think of this number as probability of being successful in my next trade.  Another way to state this is : I made a profit of 19.27% for 40.48% of my trades and I took a loss of 9.16% for 59.25% of my trades. This gives me an average profit of 2.35% / trades. An average trade was 127 bars long (~ 3 months).

The goal of a good strategy is to get the best returns with the smallest risk. So,  a desirable strategy would have :

1. A high average profit number
2. A high win rate
3. A low average barsHeld number (trade length)

Is there such a strategy out there?

A simple Moving Average Based Strategy

Let us take a look at a very simple moving average based strategy. This strategy is discussed in Beyond Technical Analysis

STRATEGY RULES :

Rule 1 : Go LONG at next days' open if 3-day SMA crosses over 65-day SMA

Rule 2 : Close LONG position and Go SHORT next days' open if 3-day SMA crosses under 65-day SMA

Rule 3 : Cover SHORT position. Back to Rule 1.

Since moving averages are lagging indicators of trend, rule 1 indicates in the last three days, the short-term price action for the
security is positive and it may be time to jump in.

This strategy is an long/short strategy is always takes a position. There is no "time-out" period. You are either long or
short with the security.

The back test results are shown below. The strategy was back tested on 5 year data with S&P 100 stocks

	All Trades	Long Trades	Short Trades	Buy & Hold
Starting Capital	$10,000.00	$10,000.00	$10,000.00	$10,000.00
Ending Capital	$11,151.13	$11,326.72	$9,824.41	$12,685.16
Net Profit	$1,151.13	$1,326.72	($175.59)	$2,685.16
Net Profit %	11.51%	13.27%	-1.76%	26.85%
Annualized Gain %	2.21%	2.53%	-0.35%	4.88%
Exposure	54.66%	24.41%	30.89%	79.77%
Total Commission	($55.50)	($33.96)	($21.54)	($4.90)
Return on Cash	$0.00	$0.00	$0.00	$0.00
Margin Interest Paid	$0.00	$0.00	$0.00	$0.00
Dividends Received	$0.00	$0.00	$0.00	$0.00
Number of Trades	620	404	216	95
Average Profit	$1.86	$3.28	($0.81)	$28.26
Average Profit %	2.35%	3.80%	-0.38%	32.62%
Average Bars Held	127.37	86.60	203.61	1,238.99
Winning Trades	251	162	89	62
Win Rate	40.48%	40.10%	41.20%	65.26%
Gross Profit	$3,935.18	$2,500.72	$1,434.46	$3,470.93
Average Profit	$15.68	$15.44	$16.12	$55.98
Average Profit %	19.27%	18.52%	20.62%	65.73%
Average Bars Held	204.39	156.62	291.35	1,229.94
Max Consecutive Winners	14	14	12	6
Losing Trades	369	242	127	33
Loss Rate	59.52%	59.90%	58.80%	34.74%
Gross Loss	($2,784.05)	($1,174.00)	($1,610.05)	($785.77)
Average Loss	($7.54)	($4.85)	($12.68)	($23.81)
Average Loss %	-9.16%	-6.06%	-15.09%	-29.57%
Average Bars Held	74.97	39.73	142.12	1,256.00
Max Consecutive Losses	16	19	19	3
Maximum Drawdown	($1,846.04)	($854.87)	($2,264.80)	($6,304.03)
Maximum Drawdown Date	10/28/2009	7/7/2009	4/14/2010	3/9/2009
Maximum Drawdown %	-15.20%	-7.87%	-18.73%	-43.94%
Maximum Drawdown % Date	10/28/2009	7/7/2009	4/14/2010	3/9/2009
Wealth-Lab Score	3.43	9.55	-1.36	3.43
Sharpe Ratio	0.22	0.40	-0.20	0.35
Profit Factor	1.41	2.13	0.89	4.42
Recovery Factor	0.62	1.55	0.00	0.43
Payoff Ratio	2.10	3.06	1.37	2.22