When you trade mean-reversion long by itself, there will be times when it’s completely flat. That means you’re not making great use of your capital. By trading both simultaneously, you better use your capital and take advantage of the fact that the two strategies are designed for two different market types, so you’re covered in all scenarios.
Here’s a table comparing the two strategies being used alone, versus together.
As you can see, the MAR ratio (CAGR divided by biggest drawdown) is excellent—and there’s almost no correlation with the benchmark.
Because it’s a mean reversion strategy, the average days in a trade is low, and you need a lot of trades. This strategy outperforms the benchmark exponentially—about four times more, with five times lower drawdowns! That’s the magic of combining noncorrelated strategy, getting maximum bang for your buck. There is a low Ulcer index, high R-cubed, and over 80 percent of months are profitable.
As you can see, the drawdowns don’t last long. We recover quickly, because trade frequency is high, and therefore opportunities abound. The pace helps you.
The largest drawdown of the long strategy was about 20 percent, but by combining strategies, it shrunk to 11 percent. The CAGR of the long strategy was 21 percent—by combining strategies, it increased to 26 percent.
The strategy has been profitable every year since 1995, even in the big bear market of 2008, when it performed 64 percent better than the S&P 500. There are only a few years in which the index outperformed this powerful strategy.
Recently, results have been mild, but that’s because volatility has been low. That leads some people to conclude that mean reversion no longer works, but that’s ridiculous. We know that low volatility equals mild results with mean reversion. You can see that in our trading rules. We simply don’t get enough trade setups, which means we don’t have lots of opportunities to create short-term profits.
Risk-adjusted returns are still good, but our net results are underwhelming. We don’t have enough volatility to see a large-enough volume of trades. Once volatility starts to structurally increase, our mean reversion strategies will see better results.
In the following table, you can see the results of all described strategies—including the benchmark (buy and hold of the S&P 500).
Clearly, all of the quantified strategies have a clear and consistent edge, and combining them increases that edge exponentially.
I personally trade a suite of twelve noncorrelated strategies, and I train most of my clients to combine all of the described strategies, if it suits their personality. The more proven strategies you combine, the higher your risk-adjusted performance. Combining all proven strategies is fairly easy to scale, and then you can have the option of adding more, later. When it comes to automated training, it truly is “the more, the merrier.” Each added strategy increases upside while decreasing risk.
As mentioned before, through position sizing, you define your objectives. First, your strategy needs an edge. Once you have an edge, position size is the missing ingredient, enabling you to trade your strategy according to your objectives and within your comfort zone.
There are many ways to define your position sizing, based on your objectives, risk tolerance, and whether or not you’ll trade on margin.
The variety of models is beyond the scope of this book, so I’ll show some simple adjustments, based on profit objectives and risk tolerance. Through the following example, you can see how position sizing affects both CAGR and maximum drawdown. For the purpose of this example, we’ll use the combined suite of long and short mean reversion. Remember: We’re trading 100 percent long and 100 percent short.
The results of trading long and short mean reversion combined are these:
CAGR: 26 percent
Max Drawdown: 11 percent
Risk per Trade: 2 percent
Maximum Positions: Ten long and Ten short
Maximum Size per Position: 10 percent of total equity
The Conservative-Sizing Model
Now, here’s an example of a strategy for the more conservative trader. This strategy is for someone who likes combining long and short mean reversion, but can’t stomach the daily and monthly swings and drawdowns. They’re too large, and he or she won’t be able to follow his or her strategy. The following is a simple adaptation for traders with a lower risk tolerance.
We basically cut our sizing in half:
We trade the same amount of positions—a maximum of ten long positions and ten short.
Risk per Trade: 1 percent
Maximum Size per Position: 5 percent
Since this is long and short combined, we can get up to 50 percent long exposure and 50 percent short (10 positions x 5% of equity).
See how the drawdowns lower from 11.6 percent to 5.6 percent? We take a hit on the CAGR, of course, but we’ve chosen that. The CAGR is still 14.6 percent—double the CAGR of the S&P 500, and the drawdown is almost ten times lower! The lower the risk, the lower the CAGR.
The Aggressive-Sizing Model
Now let’s take a very aggressive model, where we trade significantly on margin. This position sizing isn’t possible to trade at some brokers, but at mine, Interactive Brokers, this option is available to portfolios above $125,000 USD, using portfolio margin.
We trade the same amount of positions—a maximum of ten long positions and ten short.
Risk per Trade: 3 percent
Maximum Size per Position: 15 percent
Since this is long and short combined, we can theoretically get up to 150 percent long exposure and 150 percent short (10 positions x 15% of equity).
The CAGR goes through the roof, at around 40 percent annually, but of course the drawdown increases as well. Still, at 18 percent, it is more than three times lower than that of the S&P 500. As always, seeking more profit requires you to risk more.
I do not recommend trading these position sizes—most people will overestimate their risk appetite. This example was provided as a guideline to see what the impact on your overall returns and drawdowns are when you use a different position-sizing algorithm.
Summary
There are many more advanced techniques to achieve your objectives through position sizing, but that’s a little beyond the scope of this book. There are many options, and you’ll find one that suits you.
Here is a comparison of different position sizing models:
Most people wonder, These strategies look great—but are they exactly what I’ll get in the future? It’s important to understand that back tests are representations of the past, based on past data. They are not guarantees of future results.
There is only one guarantee about the markets—they always change. We’ll always have bull markets, bear markets, sideways markets, and different levels of volatility. If you have a strategy that takes all of this into account and is based on your beliefs, you will do well. That said, your results will vary based on market conditions.
I cannot promise perfect results, but I can promise that if you follow the steps outlined in the book, you’ll beat 90 percent of traders.
There will come a time when your largest tested drawdown will be exceeded. The same will happen for your longest drawdown. That’s the reality of trading. This sounds easy to handle, but if you have a tested drawdown of 15 percent, which took ten months to recover from, many people will see a drawdown of 17.5 percent for thirteen months and panic. They think their strategy is broken, because the “maximum drawdown” was exceeded. But the key word is tested. The past can approximate the future, but back tests are not perfect. Of course, the people panicking still have a good strategy. It’s not broken. The problem is with their psychology. You mustn’t have your judgment clouded by looking at your bank account. In the worst of times, still follow the strategy!
However, the converse will happen. There will be times when volatility is so high that your mean reversion strategies go nuts, and you make more money than expected. There will be another time like the dot-com bub
ble, and your Weekly Rotation strategy will go crazy. There will be good times, and there will be bad times. But you’ll be better prepared than almost anybody.
You will succeed long term if you’re consistent in following your strategy.
Remember the steps to trading profitably.
First, define your beliefs. Are you a trend follower? Are you using mean reversion? Are you combining them to increase their effectiveness? Define this, and be crystal clear. Then, make your objectives as clear as possible.
Next, define your position sizing and cut it in half to be safe—at least at the beginning of your trading.
Trading should be treated as a business. It’s your money, so be serious about it. Have a plan.
Finally, execute consistently. You can have a great strategy, but if you don’t trade it perfectly, you’ll turn a winning strategy into a losing one. You must follow your rules and refrain from overriding strategies. Ignore the news. Overreacting makes your strategies useless.
I have seen many people who have great strategies with perfect trading rules and a clear edge, but their psychology is in conflict. They can’t avoid looking at the news, and the outside noise clouds their thoughts and leads them to ignore the computer’s orders on certain days. They don’t trade when the strategy says they should. Most of the time, they missed out on trades that saw great returns. They turn a great strategy into a useless strategy because they don’t have the discipline to trade it consistently. Consistency is key.
To solve this issue, I founded a company that specializes in executing your trades. You receive reports each day, and we trade exactly how the strategy is supposed to trade. With a group of skilled people, we handle your discipline and consistency for the strategy.
We can do this in two ways:
We develop your strategy based on your desire.
You have a strategy developed, and we trade the signals for you.
(For more information, visit PerfectExecutions.com.)
If you’ve followed the step-by-step approach—first defining your beliefs, second, your rules, third, automating your strategy, and fourth, trading it—you have succeeded in creating a consistent, scientifically proven way to make money investing for the rest of your life. You’re on the path to create financial and emotional freedom—no more stress.
You can, in other words, finally relax.
The only way you can fail is if you haven’t defined your beliefs, objectives, and position sizing thoroughly. I can’t emphasize this enough—trading is virtually all psychology. You can have the perfect strategy, but if it doesn’t suit your beliefs, you will override it, and it will be useless.
It’s hard work to create the strategy, but once you’ve done it, the hard work is done. It’s hard work to define your beliefs, strengths, objectives, and exact strategies, and do the testing. But when you’re done, the process of executing your strategy is effortless. Everything is automated. It takes a half hour a day to achieve effortless financial freedom. You just need to follow the process every day, and check in occasionally to ensure your real-time results match your back testing—that nothing has changed.
Most people don’t understand the importance of the initial hard work, though, or they aren’t strong enough to be honest with themselves and admit their weaknesses.
If people are unclear in defining their trading style, objectives, and position sizing, they override their strategies. That leads to disaster. Their strategy has a clear edge—like the ones I’ve presented in this book, and executed myself—but they don’t follow it. They don’t trade every day. Or, often, they’ll do a great job for the first three months, but when a drawdown hits, they’ll start doubting their strategy, because they’re emotionally attached to the money they’re losing.
If that’s the case, then they didn’t define their objectives correctly. Drawdowns shouldn’t affect you, because we have planned for drawdowns in the strategy’s creation process. If you’re going to doubt your strategy and ignore the proven signals, your strategy becomes useless. It’s useless to put in so much work only to not follow the strategy and fail. You must be honest with yourself beforehand, then trust and follow the strategy to the letter.
I had one client who was an experienced, skilled trader, but used a fundamental approach. He contacted me because he wanted to shift to a technical and automated approach. We developed a great strategy that I could have used myself. That’s how great it was! Yet I checked in with him six months later, and he said he “wasn’t doing well”; he was down 10 percent. That was strange, because market conditions had been favorable for his particular strategy. I asked him to send me a back test, and it showed a profit of 10 percent. There was a 20 percent gap. I asked him what the problem was. He should have been happily making money.
He told me he had gotten “really uncomfortable” when he had his first drawdown, which had only been 10 percent. He skipped a couple of trades that he didn’t like. Of course, they turned out the complete opposite. He missed all of those profits, and instead of a 10 percent profit, he was on a 10 percent loss after just six months. He didn’t trust the strategy, because he hadn’t been honest up front about his risk tolerance. His position sizing wasn’t suiting his stomach. He couldn’t handle it, and he started to doubt the strategy.
He has overcome it now, but only because I worked with him to completely redefine his objectives. We didn’t change the strategy. The strategy was phenomenal. We needed to redefine his objectives, so that he could trade his strategy under all circumstances, in a clear and relaxed mental state. We designed a new position-sizing strategy that actually suited his risk profile, and now he can actually follow the strategy and execute all of the trades.
Now, it’s working well, and he is making consistent, double-digit annual returns with low volatility. He follows his strategy consistently, and he’s happy.
In my experience with managing other people’s money, nine times out of ten, people cannot handle the drawdowns they say they can handle. I trade for some of my customers, and I have to be extra cautious to be sure I understand their true risk tolerance. For certain people, I’ll only use low-volatility strategies because I want to ensure I’m within their risk-tolerance parameters. I don’t want people feeling anxious about their money, calling me up, and freaking out about a temporary drawdown. My objectives don’t matter. Perhaps a different strategy or more aggressive position sizing would have higher upside, but if it’s going to make the client an emotional mess, it’s too risky. What matters is the client’s objectives and what he or she can truly handle.
Whenever a client first defines his desired position sizing, I tell him to cut it in half, then see how it goes. When you look at your strategy’s back test, you see the equity curve rising from the lower left quadrant to the top right—you see yourself making money long term. It all looks so good and simple. But that equity curve doesn’t show your feelings when it suddenly goes down, and real money is on the line. Your retirement savings have been shaved down. Whatever you think you can handle in your current, clear mental state, cut it in half. Start there, and you can adjust later.
This is a lifelong approach, so take it slow. If you think you can easily handle a drawdown of up to 20 percent, start with an algorithm that can only get to 10 percent. You’ll be infinitely more comfortable. When you begin to observe your feelings while you’re trading, and when you’ve done it for a consistent time period and proven you can handle certain drawdowns, then you can move up. This way of trading is intended to set you up for life. It’s not about maximizing profits right away. The first six months aren’t important or profitable. It’s important to use those six months to develop the ability, skill, and comfort to follow your strategy and achieve financial freedom for life.
Your beliefs need to be based on real-life experience. If you say you can handle a drawdown of 20 percent, what real-life experience is it based on? Everybody’s circumstances are different. Do you only have your life savings and no other inco
me, or do you earn $25,000 a month on top of your $100,000 of trading capital? If you have that monthly income, you can be more lenient with your risk tolerance. You’re still covered. If that’s not the case and your pension depends on your risk tolerance, you had better be thorough and honest in determining your maximum drawdown. It all depends on you. What do you want? What are your objectives, and your risk tolerance? The answers are different for everybody.
One of my clients is an ex-floor-trader. He has seventeen years of experience, but he can’t trade on the floor anymore because they’re closing and shifting to electronic trading. He contacted me in order to create a different approach. We had a long talk about objectives. When he said, “I can handle drawdowns of 25 percent,” I asked him, “Are you sure? What is that based on?” He said that it has happened countless times in the past seventeen years. He knew exactly what it feels like, and he was sure he could handle it. I believed him, because he had experience. When a beginner tells me that, I second-guess their estimate immediately. Most people don’t know what it’s like to lose a quarter of their equity. It’s human nature to get upset and react emotionally, and you need to account for that. Failing to do so is the surest path to failure. People need to accept that they can be smart and make money while also admitting their natural weaknesses.
When I discuss drawdowns with clients, I make them visualize their account balance, to simulate their emotional response. Imagine your initial capital, then imagine the amount you have lost. Let’s say it was $500,000, and you said you can handle a 25 percent drawdown. Picture that drawdown of $125,000. That $125,000 is just gone. You look at your account statement every day, and it’s not $500,000 anymore; it’s $375,000. How do you feel, exactly? How would you feel if eight months later, it’s still below $400,000? If you’ve been trading for eight months, and lost $100,000? Would you feel uncomfortable? Would you still follow your strategy? If you translate the percentage into real money and visualize it, you can have a better view on what percentage drawdowns you can really handle, and how your emotions would change. Nothing is a substitute for real-world experience, but visualization is a good start.
The 30-Minute Stock Trader Page 11