Dynamic Momentum Trading — Part VI

This is Part VI of the Dynamic Momentum Trading series on how momentum rankings may be used to trade ETFs. It is important that the reader understand the previous posts. They can be found by beginning at Part I or by looking under the Investing selection of the main menu on this site.

The purpose of this post is to show how the numerous options in the DMS system can be eliminated without reducing the efficacy of the system.

System Options

The trading model presented thus far was established with options for testing purposes. Often critical variables can be identified but not their importance over different value ranges. The number of positions to be traded and the trading styles were two that fell into that category when designing the system.

No amount of a priori reasoning can answer how important either might be over various ranges, especially when placed into a particular model. Their own specific constructs and the constructs of a mathematical model that purports to measure the effects of current momentum on future value make such a task impossible. However, when theory cannot provide answers, empirics may.

The two variables in question are the following:

• Trading Styles: Three trading styles were built into the momentum algorithm. These were Normal, Aggressive and Conservative.
• Number of Positions: The number of ETFs that could be traded ranged from 1 to 3.

The empirics provided by extensive backtesting already performed allows reasonable answers as to the right range of values for these variables.

Selecting a Trading Style

Three trading styles are available in the model. The differences among these styles were not significant in terms of risk-return considerations. Backtesting results for trading one ETF for each style are presented in the table below.

The backtests began January 1, 2007 and ran through December 31, 2016. Each style started with initial equity of $10,000. By the end of 2016 TN1 (light green representing Trading Style Normal and 1 trade per month) had an equity of $133,824. TA1 (pink) and TC1 (yellow) representing Aggressive and Conservative trading styles achieved $119,116 and $106,160, respectively.

One Trade Per Month

The graph above is logarithmic which makes it easier to visualize the degree of correlation among the equity curves. Each tends to move up/down at the same time and roughly to the same degree. That indicates high correlation between the graphs. Put differently, each curve has similar risk(s). TN1 returned more than TA1 or TC1. Based on similar risk, TN dominates the other two trading styles.

Standardizing The Number of Trades

Not shown are graphs similar to the one above for trading two or three ETFs per month. The correlation between trading styles at these trading levels of ETFs per month is at least as high as shown in the graph above. Furthermore, there is a significant lowering of the equity curves when one trades more than one ETF per month regardless of the trading styles. To illustrate the fall-off in profits, the equity curves for TN at the three different levels of trades per month is shown below:

TN1, TN2 and TN3

TN1 is the lightest green, TN2 is slightly darker and TN3 is the darkest of the plots above. High correlation between these curves is also obvious, but each added position drives down the overall profit curve.

Similar degradation in profits occurred for the other two trading styles when more ETFs were traded per month.

Based on this simple analysis, we settle on a normal trading style with one trade per month as being the standard for this trading system. All other options are dominated by this selection. TN1 is more profitable than TN2 or TN3 with comparable risk. TN dominates TA and TC in profit at all levels of trades and does so without increasing risk. Thus, the primary focus of our momentum rankings will be for one trade per month utilizing the normal trading style (TN1).

Trading With a Screen

The Simple Switching System (SSS) was discussed as a modification to DMS and as a means of risk reduction.

A momentum indicator, called SSSMO, was created to screen trades. If the SSSMO were favorable, permission was granted to enter the DMS trade. If not, the user might want to stand aside until market conditions improved. This signal is separate from the DMS system. It need not be used or it can be used when the investor feels like using it. For those not interested in screening momentum selections based on market conditions, there is no need to read further.

Why Consider SSS?

SSS may be able to reduce the risk of trading the DMS system. It can only do that by reducing returns as well. Whether it is for you is a decision that can only be made by you. We all have different risk tolerance. We all have different personal and financial situations.

In order to judge the usefulness of SSS, backtesting provides an example of how it would have performed in the past. A logarithmic chart is used below where TN1 (our preferred trading system) is shown as the solid green line. SSS is shown as the dotted green line:

The first observation is that ending profit is reduced from $133.8K to $56.3K. Would you be willing to give up $70+K in order to sleep better? Obviously only you can answer that question and if you have not been a trader squeezed at one time or another you may think that the answer is easier than it should be.

Let’s look at the above chart a little more closely. The green and red ribbon at the bottom is the permission signal. When it is green, you trade the DMS system. When it is red, you do not. The most recent plunge in DMS in the fourth quarter of 2016 provides an example of how SSS can help. Were you trading only DMS, this portion of your wealth would have dropped from a high of (say) $135,000 to say $100,000 or about $35,000 (MDD of almost 25%). If you were using SSS as a permission mechanism, you would be out of the market and avoid this downdraft.

A more dramatic example of SSS on the DMS system occurs when the number of trades per month increases. As an example, TN3 with an SSS screen actually produced higher profit than trading TN3 alone. The period from 2007 to 2016 is shown in the graph:

The SSS curve actually substantially outperformed the DMS TN3 curve because it avoided serious losses. The period in late 2008 is a good example. SSS stayed out of the market for the better part of that year (see the level part of the dotted curve) while DMS got hit with the destruction that took place. As an aside, how might you feel trading a system that requires you to abstain from trading for many months?

That’s it for now. The DMS model will track Normal trading style with one trade per month, although rankings will show three to five top-ranked ETFs should you wish to trade more than one. SSS will be shown also. Followers will decide whether and when to pay attention to this permission switch.