We have been through the principles I highlighted in the introduction to this series in years 1–5. In year 6 I am doing something a little different and will look at the S&P500 chart for the same period and highlight the areas where the system would perform, go into drawdown and be on the sidelines. Doing this exercise will show “the understanding your system” principle.
Patience is key, we only want to be trading when the conditions suit the strategy as this period would have the highest probability of success, when the market turns down we want to go to cash and wait for the market to turn higher and then get back in. Remember we do not know this at the time, we have a set of rules to define it.
The S&P500 CAGR for 2006 was 15.75%. As we have seen from previous years we expect the system to do better than that.
On the S&P500 chart for the year we can take note of the following:
- Areas 1 & 4 — These are the times we would expect to make money during the year.
- Notice the difference in the structure in Area 1 and that of Area 4. Area 1 at the beginning of the year has deeper pullbacks whereas Area 4 in the latter part of the year moved a lot quicker with shallow pullbacks. This particular strategy performs better with deeper corrections, it is the way it was designed so we would expect a better performance at the beginning of the year.
- Area 2 — This is where we would expect the Max DD (Drawdown) to occur. The strategy is long-only buying dips in an uptrend. Around the beginning of May the market started correcting and we would not have known at the time that it would be deeper than the corrections that happened from Jan — end Apr. The correction continued deeper and losses would have been taken.
- Area 3 — This is where we would have turned the system “off”. A “downtrend” as per the rules would have been “triggered” and we would sit on the sidelines until such time as the rules defined an uptrend back in place. This happened in mid August and we would get back into the market. There is a lag from the time the bottom happened until the system gets back in to the market. Just as we do not know when the top is, we do not know when the bottom is until after the fact. We can only follow a set of rules that guide us to the periods of higher probability outcomes.
Some metrics for the year.
- CAGR — +52.47%
- Max DD — 7.17%
The equity curve above can be compared to the S&P500 and as discussed, what we would have anticipated based on the S$P500 is how the system performed. When doing monthly or quarterly reviews of your system, understanding this is key to having the trust and confidence to continue trading the system going forward. If you started trading the system in May for example you would have gone immediately into DD (Drawdown) and then been on the sidelines for roughly the next 2 months. If you do not understand your system you might walk away from it at this stage and try something else. Those with the understanding and patience would stick with it and would have been rewarded in the latter part of the year.
- Area 1 — The best performing period of the year. As per Area 1 S&P500 chart
- Area 2 — This is where the Max DD of the year occurred. As per Area 2 S&P500 chart
- Area 3 — This is where the system would be out of the market. As per Area 3 S&P500 chart
- Area 4 — Another period of performance. As per Area 4 S&P500 chart.
If you have any questions or comments please send them to me via one of the methods below:
Miguel — TravelingTrendTrader
LinkedIn: Miguel Teixeira