Filter stock trades based on the market direction
Posted: Tue Mar 04, 2014 7:27 pm
I have been trading long / short equities using mechanical trend following systems for some time. This has been quite profitable for the last 8 years so I am pretty comfortable with my system performance. I have recently been investigating the impact of turning the long side signals off when the market index is going down and turning the short side signals off when the market index is going up.
My initial hypothesis was that a trigger like this should reduce the drawdown on the long side and the short side, so when these two sides of the system were combined the equity curve should be that much smoother.
I thought this was a relatively obvious hypothesis - although often (as we know) what is apparently obvious or logical may not work in reality...
With various types of filters used to determine the direction of the index all I have found is that the equity curve degrades relative to leaving both sides of the system 'switched on' at all times.
Possible theories may potentially explain this:
1) The reduced opportunity due to the filter more than offsets any other benefit
2) When trading individual stocks with trend following systems, the stocks that make you the money are leading the market, so the lagging index filter keeps you out of the best trades
3) Combination of BOTH 1 and 2
4) Some other theory I have yet to come up with
I suspect that the main impact is from point 1 above, because when I invert the index filter (trade stocks long when the index is declining and short when the index is rising) the system still makes money (although the equity curve is a little ugly).
Conventional wisdom (not always right or useful in trading) I thought said that you should trade in the direction of the broader market, but these results seem to say trade both directions all the time to maximise your opportunity.
Has anyone had similar experiences to this? I would be interested to hear if anyone has successfully used the direction / state of a stock index to filter medium to long term stock trend trades to improve their equity curve.
My initial hypothesis was that a trigger like this should reduce the drawdown on the long side and the short side, so when these two sides of the system were combined the equity curve should be that much smoother.
I thought this was a relatively obvious hypothesis - although often (as we know) what is apparently obvious or logical may not work in reality...
With various types of filters used to determine the direction of the index all I have found is that the equity curve degrades relative to leaving both sides of the system 'switched on' at all times.
Possible theories may potentially explain this:
1) The reduced opportunity due to the filter more than offsets any other benefit
2) When trading individual stocks with trend following systems, the stocks that make you the money are leading the market, so the lagging index filter keeps you out of the best trades
3) Combination of BOTH 1 and 2
4) Some other theory I have yet to come up with
I suspect that the main impact is from point 1 above, because when I invert the index filter (trade stocks long when the index is declining and short when the index is rising) the system still makes money (although the equity curve is a little ugly).
Conventional wisdom (not always right or useful in trading) I thought said that you should trade in the direction of the broader market, but these results seem to say trade both directions all the time to maximise your opportunity.
Has anyone had similar experiences to this? I would be interested to hear if anyone has successfully used the direction / state of a stock index to filter medium to long term stock trend trades to improve their equity curve.