SCOTT WELSH TRADING BLOG

Strategies That Work When Trouble Hits

Strategies That Work When Trouble Hits

Nov. 20, 2019

The market clearly doesn’t give a rip.

A few months ago, the yield curves inverted — a sign that has preceded all of our other recessions — and the market didn’t care.

This inverted yield curve is different.

Sure enough, the market went up.

A few weeks ago, the point was made that corporate and government debt are at all time highs — just like they were before the meltdown of 2008 — and the market shrugged.

Total debt doesn’t matter. Only the growth rate of debt matters.

Sure enough, the market went up.

All over the world, countries are reporting GDP numbers that are trending lower and manufacturing is down in the United States. The world is in a slowdown.

I am not the world. I am different. And the recent rate cut ensures that the U.S. economy will keep humming along. 

Sure enough, the market goes up.

Naysayers are having an embarrassing time trying to warn against a recession.

The warning signs are no signs at all.

The bulls have it. And they’re not here for your dire predictions.

But, just for a moment, let’s pretend the market can go down.

Let’s pretend that the longest bull run in the history of humankind won’t go on forever.

I know. It’s ridiculous to even say it.

But, if it did, it might be interesting to look at some strategies that would work well in a falling market.

Because there were many traders who absolutely made a killing during the fall of 2008.

While long-only, buy-and-hold traders were suffering horrible losses and crippling drawdowns, those who were ready for the drop made 30, 50, even 100% in a single year.

So, what kind of strategy works when the fish hits the fan?

The #1 answer is trend following.

Trend following is made for times of crisis.

What’s the worst thing that can happen for a buy-and-hold trader? A severe drop. A little drop is difficult, for sure, but not world-ending. It’s the drops of 50% or more that ruin the financial future of buy-and-hold investors.

While price is dropping and ruining the lives of index funders, it’s absolutely certain that a trend has developed.

And trend followers hop on that trend and watch profits pile up while buy-and-holders are calling their brokers every day. [Do people still call their brokers?]

So, what’s an example of a system that works?

Breakouts.

Buy when price breaks above the highs and sell short when price breaks below the lows.

What’s the best instrument to trade this way on during chaos?

Probably futures. You get leverage and you get great trends. A futures trend following trader can’t wait for the next recession.

Here’s an example:

Simple Trend Following System (That Loves Chaos)

  • Rule #1: On a Daily chart, buy when price closes above the high of the previous 48 bars. Sell short on a break below the low of the previous 48 bars
  • Rule #2: Stop loss is $1,000. Profit target is $3,200.
  • Rule #3: Trade 1 contract.

(Notice how simple that is? It’s just trying to be there when a savage trend breaks out and is trying to make 3x more than it loses.)

How would this system have done in 2007-2009?

Here are the Annual Returns for the Japanese Yen futures contract during that time:

It did quite well. The max drawdown for this period was about $8,600 in October 2008.

Here’s what the entire year of trading looked like in 2008:

It still had losers but it caught some big winners also.

I used the Japanese Yen because I wanted to see what an apparently un-correlated instrument would do during a meltdown. The answer was: pretty darn well.

The dropping market was no problem at all.

In our upcoming emails, we’ll look at strategies on other instruments to see how they performed when the market went bad.

Just in case the unthinkable happens.

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.