Worth a read certainly. The main highlights from this post for me are these three suggestions:
1. Know what environment you are trading in (reverting/ trending).
2. Trading methods themselves revert (addition by David V.).
3. Track your methodology's equity curve like it was a stock.
In the context of the current market, I thought it would be a good idea to put some flesh on these ideas applied to the DVB Indicator.
Apologies in advance for the ginormo images.
1) Abnormal market filter
This is an idea mooted by Michael at MarketSci. The idea is adjust position size depending on the market's normality. If the market is behaving abnormally, then it may pay to reduce position size.
There are many ways to measure an abnormal market, but I've done this via a standard deviation filter. 60 period Stdev and 2.5 deviations. If the market is 2.5 deviations below the average, then you have a potentially abnormal and dangerous market.
Michael's approach is as follows:
The new YK approach says that (a) when the market is within the normal bands, take the full position, (b) when the market is outside of the extreme bands, move entirely to cash (these type of markets are just too unpredictable), and (c) when the market is between the two bands, take a fraction of the original position (0-100%) based on how deep the market is into extreme territory.
I didn’t have the time to analyse the position sizing element, but that certainly looks a sensible approach.
My rules were more simplistic: If the market is 2.5 standard deviations below average, stop trading the system.
Here are the results:
2) Equity Curve surfing
This filter applies the Parbolic Time Oscilator (PTO) to your simple (non compounded) equity curve. The PTO applies a parabolic score your curve and measures the amount of time the curve is above or below the parabolic. Applied to an equity curve, this means exiting a trading strategy when the equity curve has dropped below the parabola for longer than usual.
I set the filter as follows: Exit the strategy when the PTO is above 0.75. Again a position size filter would be better, for the sake of time I just looked at all in or out.
Again, this filter would have helped recently with an improved MAR and only a slight decrease in CAGR.
3) Abnormal Equity Curve
This method applies same abnormal market logic as before, but applied to your equity curve instead. Rule: Exit when equity curve drops by 1.5 standard deviations.
The CAGR drops, but the draw down decreases by a greater margin, this increasing the MAR. Again, 2011’s gains would have been preserved.
4) Environmental filter
Is the market suitable for pull back type strategies? What if the market is more trend following at the moment? In this case it might be better to stop fighting the tape.
One excellent trend following tool on the SPY is the Livermore Trend Indicator (DLTI) which has performed brilliantly of late. This bespoke tool is available within the DV indicators package.
Essentially, this method only activates DVB longs and shorts in line with the DLTI
CAGR and MAR don’t improve too much, but the Sharpe ratio and Sortino improve as the equity curve smooths out.
There’s no definitive answer here, but applying all or some of these principles could really help in turning trading strategies on and off.