Tharp's Thoughts Weekly Newsletter (View On-Line)
Early Enrollment Discounts for Ken Long's Workshops Expire Soon
The Power of Back-Testing by Ken Long
Trading Tip Many Ways to Play a Directional Turn by D.R. Barton, Jr.
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The Power of Back-Testing
Traders typically have some firm beliefs on back-testing. Some believe it’s required, others think it’s useful, and there’s a group that thinks back-testing is a way to fool yourself. I’ll give you some of my thoughts on why I believe that back-testing is a crucially important aspect of understanding your system. Even an experienced trader should carefully consider the results of a detailed back-test when taking on a new strategy or operating in a new time frame so that he or she is not misled. I’ll also provide some of my views on the limitations of back-testing because they are significant and not to be overlooked.
Back-testing can take many forms: on trading platforms, in back-testing software, on paper, over long periods of time or only in specific market types. Rather than spending time considering the types of back-testing, however, I think your level of back-testing is a more important consideration.
In some cases, experienced traders may only need minimal back-testing to be convinced that an idea is worth trading with live money at a reduced risk level if it is similar to systems previously traded that were reliable. In other cases, they may want to fully check out a new idea before trying to trade it live—even with small position sizes.
Properly constructed, back-testing will identify whether or not an idea has a persistent edge and under what conditions that edge will manifest. By properly controlling different parameters, we can isolate the ones that add the most value to this particular proposition. We can test for robustness and see how sensitive the edge is to changing parameters.
We may be able to identify specific market conditions where the edge is significant and tradable. We may be able to identify a subset of the total market trading targets in which this idea works best.
A particular edge may not convince some people unless they see it work over multiple time frames, in multiple markets and in all different market conditions. Others are satisfied that an idea only has to work within the definable set of parameters to be tradable. This is a matter of beliefs and personal taste as back-testing is not an academic exercise in the pursuit of the absolute truth. We’re traders, we want to make money.
What Back-testing Can Tell Us
Back-testing should tell us the likely win rate percentage, the importance of slippage and commissions, the trading frequency, the maximum adverse excursion, the longest normal winning and losing streaks, and the maximum and average figures for both wins and losses.
One of the most important result sets for analysis is the distribution of results in the form of a frequency histogram. We would like to see a somewhat normal distribution that has most of the trades clustered around the mean with an orderly profit tail to the right that suggests we have the possibility of large winning trades. We would also like to see a carefully controlled left tail of losses, which suggests that we are able to engineer our risk carefully.
Under these kinds of conditions and looking for this kind of information, back-testing is an important part of the trader’s repertoire. Having robust back-test data in hand allows us to determine where, when and under what conditions this idea is tradable and the expected results. When we proceed into live market trading as a prototype system with reduced real risk, we can then compare actual results with live money to see if the trade can be managed as intended.
Limitations of Back-testing
As much as back-testing can reveal, it can also fail to reveal that one overlooked truth can be mortally dangerous for traders. Back-testing results provide historical performance but they do not forecast how a system will perform now. This is perhaps the biggest challenge with back-testing.
Even if a trader performs a rigorous back-test with full knowledge of the limits of its ability to forecast into the future, it's common to see a large discrepancy between back-test results and actual results from live trading. This phenomenon has several potential sources. Sometimes, back-tests are conducted in isolation and not as part of a full portfolio of strategies. Often back-tests may use optimistic values (though they may have seemed realistic at the time) for slippage and commissions. Many times back-tests are simply unable to integrate the human dimension of executing a set of trading rules. Experience shows me that this is perhaps one of the most important aspects overlooked when evaluating back-testing results.
Regardless of the reasons, some traders place so much reliance on their back-testing that very different live trading results fail to convince them they missed something important in their back-test. They might persist in trading a system that will simply not work in the real world. This situation illustrates the combination of an overconfidence bias and the need to be right.
Professional engineers and doctors are especially prone to this problem because of their belief systems and testing experiences from their previous professions. Those professions place a premium on being right to be successful. Yet in trading, the ability to act with incomplete knowledge and the willingness to be wrong can lead to excellent trading results.
Also, there is always a real danger of curve fitting and data mining to find a perfect system that would have worked with an exact set of market conditions in the past. The obvious predicament that thinking poses is that those conditions can never occur again in the future. Perfect fit system thinking neglects the reality of the market as a complex adaptive system that never shows you the same face twice. It also exposes the problem of over reliance upon the power of computation.
Back-testing offers many powerful advantages to the professional trader. At the same time, it must be undertaken with full recognition of the limits of its usefulness. The professional trader will take back-testing results into consideration as a way to select particular systems to prototype. In the prototype phase, the trader fully engages real money, real markets and the human factors where you can generate real world results. If the real world results prove attractive, then you can commit the system to full position sizing methods or “full production mode.”
Winter 2011 Workshop Schedule
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The Many Ways to Play a Directional Turn
Last week’s article on market extremes elicited several types of responses from readers. There were the very kind thanks for the insights (always appreciated on this end!). There were references to others who had similar opinions (thanks for the insights!). And lastly there were the requests for how to play the potential drop in the equities markets from these lofty heights.
In response to those requests, I have to remind everyone that Tharp’s Thoughts is not a trading recommendation newsletter. On occasion, we present research intended to provide insight into current market conditions that could help traders and investors formulate trading ideas. Providing individual trade recommendations, however, is outside the scope of our purposes for writing here.
With that said, I thought it would be instructive to present several possible ways to play this potential market-topping action. Let’s look at some different ways that a trader might express that the idea of a potential correction. First, let’s review where we are.
This Market Is Technically Stretched
Last week, we looked at a couple of factors that pointed toward a stock market that is overbought and due for a correction. One of these indicators is the chart from last week that showed accelerating price activity.
Since last Tuesday, one market maven has told me, “General market activity has kicked another leg out from under the stool,” meaning that even more elements are pointing to a market correction. First is the general retreat of the commodity complex where most of the major dollar-denominated commodities (gold, oil, etc.) continue to head down.
And as we see in the chart below, acceleration lines are being broken and the subsequent rebound has yet to reach new highs.
Last week I said that one could play this potential market-topping activity by trading the correction. If that correction failed to materialize, you could reverse and play the breakout.
Today, though, let’s look at several ways that you could express the opinion that the market might go down a bit.
Multiple Ways to Play a Potential Market Drop
For this exercise we’ll concentrate on the S&P 500 index, noting that there are similar trading instruments for other market indexes.
Let’s look at a laundry list of ways to trade a market drop:
- The time honored way would be to sell short the index. One could do this by selling the futures contract (S&P e-mini symbol:ES) or selling short the Exchange Traded Fund (symbol:SPY).
- Tax-advantaged accounts (e.g., IRAs, SSRPs and the like) will not allow the use of margin that is required to sell short. For those accounts and really for any trader, there are inverse Exchange Traded Funds (ETFs) that rise in price by an equal percentage to the underlying index’s drop. For the S&P 500, one such ETF that trades over a million shares per day is the Proshares Short S&P 500 (symbol:SH).
- You can also add leverage to your inverse ETF by buying the UltraShort ETF that rises twice as fast, in general, as the market falls. The symbol of the most popular 2x inverse ETF is SDS. Over the past year, this ETF has had an average volume between 25 and 58 million shares per day! With the market at more extreme overbought levels today, SDS is trading at its lowest volumes of the year, but still averaging around 28 million shares a day!
- For even more leverage on a stock play, there are 3x leveraged ETFs such as SPXU, which is trading over 4.5 million shares per day.
- Of course, for really high leverage, one could buy options (puts) on stock for a higher reward-to-risk profile (for example, puts on the SPY). With this play, one would need to manage time decay, volatility changes and the other challenges involved with buying options premium.
Before we move on, let me remind everyone that leverage is very much a double-edged sword. While leverage offers the allure of higher returns, it also demands an increased need to manage a much higher level of risk.
Now, the number of ways to trade a correction is almost as limitless as your imagination; let’s look at one final way to play it. A professional money manager might incorporate leverage and risk controls with the use of an options spread. In this case, with the SPY currently trading at just over 129, you could buy an April 129 (at the money) put for about $4.00 and sell an April 125 (out of the money) put for $2.60 or a net cost of $1.40 per options contract pair.
Your downside risk would be strictly limited to $1.40 per position and your maximum upside is $4.00 per position. Of course by using a stop loss that kicks in before the spread price drops to 0, which is how most would play it, this spread presents a very good reward-to-risk profile.
For all of these trades, the protective stop loss could be placed just above the recent highs. Depending on how aggressive you’d like to be and your time frame expectations, one might place the stop 0.25 times to 1.5 times the Average True Range above the recent highs (or below the lows for the inverse ETFs).
A reasonable first profit target for a correction is the 124 – 125 area on the SPY.
I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…
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