To Buy Or Not To Buy The Dip?

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Buying the dip in US equity market’s this past year has been quite a lucrative strategy. So much so it has pushed me to develop a few automated trading strategies that focus on just that, buying the f%&!ing dip (or BTFD as we traders like to call it)! Here is the equity curve of one of my automated systems trading the DOW 30 individual stocks along with a few sector ETFs:

equitycurvefeb4

Not bad! After 1000 days of backtesting, roughly 400 trades, 25% of account per position, and a starting account of 100k, we would be sitting on just over 450k today utilizing this strategy! Indeed, this system looks for BTFD opportunities… pullbacks in an overall bullish uptrend, taking advantage of the natural bullish bias in equities. Important note, the highest drawdown this strategy experiences is 16% (on gains of roughly 350%)!

Now the edge in buying the dip is clearly there, as confirmed by this strategy equity curve. But like anything in trading, nothing is that easy. There will be market environments where buying the first down day in stocks will be unprofitable (and maybe painful if you bought last week!). So how can we determine that a given market dip is more likely to exhibit this trend-reverting behavior than others? There are a couple things I like to look at to put the probabilities in my favor:

1. Macro trend follow through: Is the current market drop caused by some strong macro factor? (Yes, in this case EM currency crisis, economic slowdown)… Are we continuing to exhibit action conducive to the original market trigger? (No, emerging market equities bounced back strongly today after yesterday’s drop, where as developed markets were weaker, see image below).

emturnaroundfeb4

Note EM equity rebounded relative to developed markets today… this is not showing macro trigger continuation and is a clear indication that we may be nearing a bottom of this market dip.

2. Are internals confirming? Not particularly. Financials have held their ground (the biggest statistical bullish edge of all sectors) and volatility remains within the realms of other recent market pullbacks (the VIX stands below 20 as of today’s close).

All in all, this market is most certainly weak, but there are clear statistical bullish edges appearing after the S&P 500’s 100 point drop from highs. It’s much easier (and logical) to be buying here rather than selling. I  will continue to buy new lows as long as EM remains stable. Should EM become dislodged, we could be seeing a real market route, and in that case, the market BTFD environment will have changed.

The Golden Rule of Trading (For Me!)

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I do a lot of thinking about what constitutes being in “the zone”. Being in the trading zone means you are one with the market, you are trading according to risk management guidelines, you are being patient… you just seem to be getting the market right every time. Obviously, it is very difficult to stay in the zone consistently. Every trader goes through his/her ups and downs, but of course the ultimate goal is to stay in the zone as much as possible and thus be banging out solid returns. Understandably, it can be extremely helpful to observe and study yourself once you have recognized that you are in the zone. Being able to fully understand what mental state and the traits you embody during winning times can help you win more often and consistently (practice, practice, practice!). Most traders are taught to focus on their losers, (and that is very important no question… learn from mistakes) however they are not taught to learn from their winners, and to me it is equally as important.

So with that in mind I like to look back at my best winning trades. The best trades for me of course fit within my trading methodology. They typically start out when I have a strong macro view on the general markets, and one of those macro markets are in a position for a high probability move in the direction conducive to my macro view. But as I look deeper into those trades that perform so well, I realize that it is not the actual macro view that generates the alpha, rather it is the active management of those core positions based on the macro view. The macro view simply gives me the confidence in “knowing” where the market is going to go from point A to point B, the alpha for me however is generated in the movements between the two points.

It is commonly stated towards traders that the best pathway to success is to follow your plan and trading rules. But through observation, some of my best alpha generating trades (when I am in the zone) seem to embody a couple rule-breakers! The trades where I follow my rules to a T are good, but they aren’t great. So I now have a Golden Rule: ALL RULES ARE MEANT TO BE BROKEN!

It’s best to demonstrate this concept with a past trade example. Below is a 120 minute chart of the 10 year note futures since the start of December to the present. Due to multiple macro reasons (taper, fund flows, time-factors) I had a strong inclination (and continue to have one) that interest rates would rise. Understandably, one rule of mine is to hold my positioning as long as the underlying macro factors don’t change. So I got short and held into November’s NFP report. It came out solidly bearish bonds and pro-taper! My trading plan would tell me to hold short, but instead I covered because the market action did not confirm the macro reasoning. The blow-out number should have caused rates to rise much more, but yet it didn’t. Notes indeed reversed and rallied after the report day, and I then re-entered my covered contracts to lock in a much better return.

10 year brody

I look at the management of this trade like I effectively took a long position after the NFP report. The macro picture would have told me to stay short, but instead by covering contracts, I effectively went long on a shorter time-frame, because I knew the market action was telling me something different. This is why trading plan rules in certain circumstances need to be broken, because the market does not follow anyone’s rules. If you are in the trading zone, you are one with the market’s action. If the market is telling you something different, LISTEN!

Stock Indexes Are Trendy?

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It is a common concept that stock indexes are one of the most rotational asset classes out there. In this case, by rotational I mean the tendency for the market to mean-revert is much higher than it is for the market to continue its underlying direction for “rotational” markets. Through certain lenses, this is certainly true. If you were to backtest buying -1% down days in the S&P 500 over the last 15 years and selling the next day, you would effectively beat buy and hold. This shows that stock indexes have a tendency to back-fill after capitulation down days (taking advantage of the rotational “personality” of stock indexes, along with the clear bullish bias). It is also assumed that other asset classes, such as commodities, tend to trend better than stock indexes (whether it be simply due to lower liquidity, or the absence of  the multiple components a stock index has). That could very well be true, considering the fact that the very same backtest described above performs much poorly in other markets such as oil and gold, (who have also seen overall uptrends over the last 15 years) meaning there is a higher tendency for the market to continue the initial down move. However, looking at “trendiness” from the lens I am about to show you, shows otherwise.

Today I performed a very simply test in 5 macro markets: the S&P 500 e-mini futures, oil futures, gold futures, EURUSD, & USDJPY. The test was also performed with all the data I had available to me, meaning some sample sizes were higher than others with regards to time-frame tested. I was testing for a very simple pattern and the idea was as follows:

If we have a powerful trend day (a day where a large move occurred in the up or down direction), what is the tendency to see continuation to at least some degree the next day? 

To test this I need effectively 2 data sets: 1. the base test (# of powerful trend days) and 2. the continuation test (# of continuation days). A powerful trend day was defined as any day where my ROCATR indicator (a one-day ROC indicator normalized with the last 10 day average true range) touched an extreme to the upper or lower end, where as a continuation day was simply a day where after a bullish powerful trend day we would see a higher high than the trend day’s high, and vice versa for bearish powerful trend days. Next, I take the number of continuation days and divide it by the number of powerful trend days to give me a percentage that tells me the tendency for a market to breach an extreme (high or low) after a powerful move. The results per asset class are as follows:

S&P 500 – 82%, Oil – 79%, Gold – 78%, EURUSD – 73%, USDJPY – 61%

These results tell me that if I were to buy every powerful up trend day, sell every powerful down trend day, and put my target one tick above/below the high/low of the trend day in the S&P 500 futures market, I would have an 82% win rate. Through this lens, it looks like the S&P 500 can be trendy sometimes! DO NOTE however that this does not mean the market closes the day in the same direction the next day. It simply means that we at least wick above or below the extreme the next day.

This information can be extremely helpful to the day trader, who might have thought the high probability trade was to fade the large move at the close of trade, but also helpful to the swing trader and systems traders who are looking for new edges to take advantage of.

 

What is Your Edge?

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Before a market participant risks his money in the volatile financial battlefield, he must have reason to do so. We traders are here for one thing: we have a defined advantage that allows us to bet on specific market outcomes which will keep our account balance positive given enough time. This is called our “edge”, and it is the reason why we trade.

Trader edge’s can differ wildly from person to person. It can be completely discretionary, a mix of systems and informed decision making, or completely automated. It is extremely important however that you know exactly what your edge is, and it is prudent to write it down and define it.

So here’s my edge (taken from my trading plan):

What is my edge? What market inefficiencies am I taking advantage of?

Simple Answer: Market Cyclicality & Market Positioning Imbalances

Market Cyclicality: Markets do not just go from point A to B. Assets go through a process called price discovery when re-pricing, creating many cyclical fluctuations, even when the asset is in a general overall trend up or down. It is these fluctuations that one can profit from. Market cyclicality is also granular as it can be observed on many different time frames. The key is to take advantage of a cycle on one time-frame, assume the risk of that period, and target a larger time-frame cycle / move. This allows us to take high reward to risk positions.

Market Positioning Imbalances: What in the end causes the market to move from point A to B? In the case of the most liquid markets I trade, macro catalysts drive the market up and down on a day to day basis. These macro “events” include:

-Economic reports, data

-Fiscal & Monetary policy releases

-Overall market flows and relationships (and how they change)

The current market price reflects the perceptions of participants regarding future macro events. The main theme driving the market a certain direction over a certain time-frame can either be crowded by market participants or under-exposed. It is important to recognize which is in play (crowded vs. under-exposed) as identifying which will indicate whether to follow the trend of the market or look for a reversal.

How to Recognize the Trade Opportunity?

To recognize a potential trading opportunity, I must be able to answer the following questions:

  1. What macro catalysts & themes are driving current market flows?
  2. At what point are we between A and B in the current market cycle (are we beginning to become crowded, or are we just getting started)?

The answer to these 2 big questions gives me a trade bias. It answers how I should be positioning myself in the given market place. To determine my specific trade entry & execution, a few more questions need to be answered:

  1. Are we in a trending or mean-reverting market?
  2. Where can I enter (technically speaking) so that my position achieves a favorable reward to risk ratio (larger than 1) and is aligned with the previous 3 answers?
  3. What is my conviction on this position? Is it something I am familiar with? If my conviction is high, I want to make sure I am sized appropriately.

These final 3 questions answer where I should enter, place my stops & targets, and how much size I should put on. The final question is very important, as it is what determines those homerun trades. I want to make sure that when I have recognized a good trade, I am sizing up and taking advantage of the market opportunity. There are times to leverage up and cut back appropriately!

What’s YOUR edge? Comment below!

Trading Notes From My Daily Market Preparation Entry For October 30th 2013

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Below is an excerpt from my personal daily market preparation entries for today, October 29th, 2013. Enjoy!

General Market Briefing:

S&P 500 – A much needed pullback was realized in today’s FOMC session. From a macro point of view, nothing changed out of the Fed and thus I see no reason why we should assume we just saw a ST-MT top in US equity. This tells me to continue buying dips on strengthening internals.

Bonds – Looks like we could have put in a short term top in the bond market. Unlike the US equity market, the macro trade in debt is to the short side. It seems as though the Fed is OK with slightly higher rates and so it looks like might be putting in a top, with potential for a resumption in the downwards trend. I remain long small 10 year, just to see how we play out tomorrow.

Oil – We confirmed the downward trend resumed yesterday and as expected, we are approaching short-term lows. I expect we break those lows tomorrow where I hope to be short into the event. However should we break 96, I will look for action that may indicate capitulation to purchase.

Gold – FOMC reaction down did not change the overall picture on gold: Fed remains committed to its QE program, the trend is higher, and we are simply taking a rest. I will look to bid gold aggressively tomorrow.

US Dollar – The dollar saw continued strength with FOMC. One could argue that the dollar was extended to the downside and that does look like it was the case; traders are simple squaring up crowded positions. As long as we stay below 80 and don’t break higher with conviction, I will continue to play to the short side.

 

Current Positions:

Long 10 Year Notes – watching this position really closely now, I covered some at the highs today but I do think the move in fixed income was convincing. Will be watching for a resumption of the “Fed is OK w/ higher rates” theme.

Long GBPUSD – Cut some size today opportunistically, but the pair continues to go against me. Will be watching the 1.60 level closely.

 

The Bottom Line:

No change in FOMC, so continue to trade with the overall trend. That means long equity, short oil, long gold, & short dollars (neutral in the bond market, need more confirmation about a direction).