Paratrade Systems Weekly Research News

24 Mar

Shock me, just not too much

If we go through an extended period of relatively low volatility in the S&P it’s easy to get periodic large moves in either direction that then feel like a shock since we have been nodding off. We then want to know how to react. Is this a breakdown/breakout so a new trend has begun or is it the pullback we should buy?

Let’s set up some conditions:

  1. The true range must be greater than the highest true range of the last 10 days.
  2. The close must be lower than yesterday’s close.
  3. The close must be greater than the lowest close of the last 2 months.

The third condition prevents us from buying volatility increases during a meltdown. We’re going to look at different holding periods so we will require rule #3 to be true for every intervening day as well.

Holding Period Total Events % Profitable Total Profits
1 118 67 306
2 114 68 575
3 109 68 725
4 107 66 861
5 102 64 1266

The data since 2007 shows us that recovery takes a few days. After five days one can assume that the shock has worn off and our returns will merge into the average for the period. The average five-day return is 2.482 points. For the entire period, the market gained 1200 points over 2307 days. That works out to a similar average daily return but the drawdown circumstances are radically different. There is only one meaningful drawdown – Dec. 8, 2014.  Other than that the equity curve is beautiful.

The approach will not get us into a strong rallying market since we may be left waiting for a shock and one may never arrive. This does speak to our current conditions.

On the flip side we could ask if a high volatility breakout is a good way to get long. Here are the conditions:

  1. The true range is greater than the highest true range of the last two weeks.
  2. The close if the highest close we have had in the last two weeks.

I could use one month instead of two weeks or 1 week instead. Neither will change the result(s). Using the two-week example we have 37 cases and over a 5-day holding period, we would have lost a total of 177 points. A monthly look back suffers an 83 point loss. Successful high vol. breakouts are difficult to find for the S&P 500.

Lastly, we could add an additional filter to only buy pullbacks if we have gone through a low volatility period. The condition would be something like: Highest 10-day close minus lowest 10-day close is less that 2 average true ranges. When I add that filter, it does reduce the number of occurrences (t0 37), but the probability of winning drops to 25%. The total number of points earned = 446. Perhaps counterintuitively, a big pullback matters just as much in a higher volatility environment as it does at the end of a lower volatility period.




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