Horses For Courses

May 20, 2020

Does that flashy new system on the internet really work well in all timeframes?

Does it really work well on all instruments?

While there are general, timeless principles that endure, there appear to be drastic differences in specific circumstances.

To use a sports example, some horses run better in certain conditions. Some horses love a dry track and others like it muddy. Some excel at short distances while others like to go longer out.

Even a great horse can perform poorly on the wrong track in the wrong conditions.

Furthermore, some football teams are great in cold weather and not great in heat. Some businesses thrive in a surging economy and go out of business when things get tight.

And trading is no different.

Buying a stock at 50% off is a timeless trading principle. We know it’s worked in the past and will work far into the future.

But buying a soon-to-be-bankrupt Bear Stearns at half price, however, is not the same as buying a company loaded with cash and high margins.

A value investing strategy needs a company that actually has value.

Trend following is also a timeless principle. There will always be trends in markets.

But does it make sense to use a trend following strategy on something that doesn’t trend?

A hard-core trend follower will say, “Yes, you have to trade everything the same.”

But we can do better than that.

We can use the right horse for the right course.

For argument’s sake, let’s look at the basic trend following strategy from last week: monthly highs. If price makes a new high, it could be a new trend, so it’s time to enter.

But let’s not put that strategy on just anything. Let’s use the right instrument on the right strategy.

So, we’re going to put the Monthly High on a stock that trends. How do we know a stock is trendy? We can look at beta.

Beta is a measure of how volatile a stock is in relation to the overall market. A beta of 1.0 is normal. That’s typical movement.

For a trending stock then, we would need something with a high beta, something higher than 1.0.

How about Apple (AAPL)? AAPL’s beta is 1.17. It’s greater than 1, so we can guess it will do well in a trend following system.

Here’s how AAPL did on the New Monthly High system (buy on a new monthly high, sell when price makes a new monthly low):

It did very well.

What’s another stock with a beta above 1?

How about Amazon (beta 1.35)? A beta that high should work in our system. Here’s the Curve:

AMZN also did well.

What about a low beta stock? My guess is that a low beta, non-trending stock would not do well with our new monthly high system. Is that a good guess?

Here’s the Curve for PFE (Pfizer, beta of 0.71):

Unsurprisingly, PFE did not do well. How about one more low beta stock?

Here’s another low beta-stock, IRM (Iron Mountain, beta 0.71):

Once again, a non-trending stock didn’t do that great on a system that depends on trends.

It begs the question: how come we’re not allowed to pick-and-choose our horses in trend following systems? Why do we have to trade every instrument exactly the same?

The possible answer? We don’t have to do that at all.

We can use our brains and choose trendy instruments for following trends.

In our next email, we’ll do exactly that. We’ll see if it helps to match the instrument to the system.

Talk to you soon.

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Disclaimer:
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.