Earlier this week, I posted an idea for a trading system. The concept was to come up with a potential system around the SPY. I always start with the SPY - it is our S&P 500, I know this index the best. I start by looking at an un-leveraged system around the SPY, then if I think I've found an edge, I will explore leverage (either broker margin or using leveraged ETF). I also will look to broadened out to other ETF's, starting with the US Indexes (i.e. QQQQ, IWM), then other countries (i.e. FXI,EWZ), then on to sectors (i.e XLE,XLF). If this system works across various ETF's, then you know you've got something. Robustness is important.
I put up a new page with the definitions for Trading System Performance Metrics. I will go through these metrics as they relate to the SPY DD System (DD means nothing, I just needed to give it a name) in this post.
Why ETF's? They are the easiest to create a system around. Clean, free data is available (can't say that for stocks, with survivorship issues and all). They generally mean revert well and that's I how I trade.
Exposure - 56% - I'll be in the market about 1/2 of the time. Good to know.
CAR% - 26.07% - This is not bad. I wouldn't mind earning 26.07% for 10 years. I've seen better, but for the SPY, this is good. And it is not all about annual return %. Drawdowns and volatility matter.
RAR% - 46.39% - this is CAR/Exposure. I would like to see this minimum 50%, so it is a little below that. But close enough to remain interested
Recovery Factor - 9.59 - Net Profit divided Max System Drawdown. Measures how fast the system recovers from drawdowns. 9 is very very good.
Max Drawdown - 20.89% - Looking back at the last decade, would you be comfortable with the biggest unrealized portfolio loss (based on closing prices) being 21%? I would, considering what buy & hold went through. But the size of the number isn't that important, it is the length of time. That 20.89% drawdown was recovered in 17 trading days - that is fast! Now there was another drawdown in 2002 that peaked at 14% and lasted 183 trading days - that is a long time. My confidence would be shaken if I sat below peak equity for 9 months. It is important to view these drawdowns in the context of time.
CAR/MDD and RAR/MDD - these should be above 1 and 2, respectively. They are, but not by a lot.
Profit Factor - 2.12 - Profit of winners divided by profit of losers. Above 2 is great. Above 3 is excellent.
Payoff Ratio -1.2- average win/average loss. Above 1 please. Check.
Sharpe Ratio - 2.25 - Above 1 is good. Over 2 is great.
DVR Ratio - 1.6 - Above 1 is good. Over 2 is great.
R-Squared - 0.71 - Closer to 1 means the portfolio moves in a straight line. It measures the smoothness of the returns. R-squared is a function of drawdowns, the less DD's, the higher R2. 0.71 is pretty smooth.
# Trades - 593 - so that is about 60 year or 5 per month. I can handle that.
Avg Bars Held - 3.61 - good to know how long I expect a normal trade to take. When trades stretch well beyond the average holding period, it usually means I'm going to end up with a loser.
% of Winners - 63.74% - This is OK for ETF's. The systems I trade now are all above 70%, some are in the 80's. Again, it goes back to what you can handle. Am I OK with losing 4 out of 10 trades? Especially when my losers are barely less than my winners, in terms of profit %. (1.36% W vs. -1.15% L).
Avg % Profit/Loss - 0.45% - Obviously must be positive to even consider a system. 0.45% is OK. I've seen ETF systems that are in the 1.5 -2 % range and stock systems around 4%.
Avg. Max Favorable Excursion - 1.68% - MFE is the maximum profit that the trade had before the trade closed. The average gives me an idea of the average positive move the trade makes.
Avg. Max Adverse Excursion - (1.34%) - MAE is the maximum loss that the trade had before the trade closed. The average gives me an idea of the average loss move the trade makes.
If I view these together, I can expect the average trading range to be ~3%. This is not that bad; I've seen systems that would have ranges 5 times that. It just gives me an idea to the volatility of the trades. Can I stomach them?
That is basically what I'm looking at when considering a system. Also, I look at the individual trades themselves. This system buys weakness and sells strength. It goes against the grain; psychologically this can be difficult. Below are some trades during June - August, when the market was volatile and these trades may be considered 'sketchy'.
Conclusion: I do think this system could be traded in real time. But I won't know for sure until I start. Also, I've already screwed around with variations of this system (using leverage, scaling in techniques) and using a basket of ETF's vs. just one. I have found some better % returns but crazier drawdowns, others have lower % returns but very small drawdown and a great average % gain per trade, and others have great metrics all around except they are barely in the market to provide a meaningful annual return. It really depends on what your style is, then optimize from there.
There are lots of things I surely am overlooking, but this was a good exercise to get the brain juices flowing.
Below is how a few random ETF's performed from 2000 - 2010 on the DD System. These are not bad, but not great.
% of Winners
Max. Sys % DD
Avg % P/L