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One Indicator, 400% Gains?

Monday, November 1, 2010 | Ed Pawelec

I've been "in the matrix" for the past couple of weeks, getting everything ready for the release of my new trading service, Price Shock Trader, coming up on November 16th.

In the meantime, I've been keeping a close eye on the results of one of my personal trading indicators that I first shared with you back in April.  The results have been positive, to say the least:

15 total trades triggered, 13 winners.  Rolling over profits, anyone using this indicator to trade could have more than quadrupled their money.

Before you get too excited, it's important to note that this indicator has triggered at an average rate of only once per year for the last 15 years ... yes, it's pretty much the opposite in the "action" department from the methods I'll be using in
Price Shock Trader.

Nonetheless, it's turned out to be a highly reliable trading tool, and I'm happy to share it with you today.

-- Ed
 
 
Predictive VIX -- Part II

It has been a long time in coming, but I have been patient. 

The very first article I wrote for Tycoon in April of this year (Predictive VIX) discussed a back-tested method that takes a position in the SPDR Trust (SPY) based on what I call the “Up/Up Indicator”.

The signals have proved to be rare, but the latest one was given based on this past Monday’s closing values.  Let me review the methodology to put this in context.

Two conditions must be met:

1.    The SPY must close higher than the prior day’s close by any amount.

2.    The VIX must close higher than the prior day’s close by more than 5%.

On Friday, October 22, the SPY closed at 118.35 with the VIX at 18.78.  On Monday the 25th, the SPY closed marginally higher at 118.70 and the VIX closed up 5.7% at 19.85. 

Right off the bat, I know that I will hear some grumblings from long-time market watchers about the fact that the volatility tends to be depressed on Fridays ahead of the weekend.  Generally speaking, this is true, and with this indicator it did come into play: 9 out of 16 entry points came on a Tuesday, meaning that the up/up comparison was made between a Monday and a Friday.  However, a positive change of 5% or more in the VIX should be large enough to overcome any weekend biases.

Now that the signal has been given, I compare the SPY close on the day of the signal and compare that to the SPY close 60 trading days prior.  Note that I emphasize trading day, so 60 trading days approximates to one quarter, or three months. 

If the comparison close is less than the current close, then a long position is taken in the SPY.  If the comparison is greater than the current close, then a short position is taken in the SPY.  In other words, the Up/Up Indicator provides an entry point for following the trend.  The position is expected to be held for 120 trading days, inclusive of the initiation day, unless there is another event that either confirms or reverses the trend.

In the case of another up/up day that confirms the trend, a new 120 day holding period is begun without closing down the original position.  If the up/up day suggests a reversal of the trend, then the initial trade is closed and the opposite trade taken with the expectation of a 120 day holding period.  I’ll talk more about that in a moment.

I reviewed and updated the data that was the basis for my original article on this indicator.  I did find a couple of day count errors and a missed signal as I reran the numbers.  The impact was small, increasing the total return by roughly 2 percentage points or .5% of the previous value.  Therefore, I believe this information to be more robust.  The revised table is included below ...
 

The first thing you probably notice is that most holding periods don’t work out to 120 days.  This means that, for the periods that were longer, there was another up/up day that occurred during the initial holding period.  Using the same method of looking back 60 trading days from the more recent event, a new 120 day holding period was begun without actually closing out the original position.

In the 2 situations where the holding period amounted to less than 120 days, the up/up day indicated a reversal of the trend.  Notice that, since I cannot know for certain that an up/up day has occurred until after the close of business, a position cannot be initiated until the next morning’s open. 

When there is a reversal, both the closing of the original position and the opening of the new position are done on the following day’s open.  For example, the second trade for the indicator was a short position established on September 4, 1996 at 65.75.  However, on November 18 the SPY closed higher by $.05 from its previous close and the VIX jumped 5.3% from the close on November 15 (yep, there was a weekend in there).  So the following day, on the opening print, I bought back the short and went long at the same time.

For positions that are held for 120 days or longer, a market on close order could be used so the closing print on the 120th day is the final value.

As you can see in the table, there have been no losing trades on the long side, although two of the gains were rather meager.  Also as you will see in the chart below, the indicator gives no indication of how volatile the holding period might be.
 
I have circled in blue the periods that exhibited significant volatility or resulted in large draw downs before becoming profitable.  In other words, holding the position does not necessarily translate into immediate profits, and my feeling is that we are currently in a period that might exhibit some excessive volatility.  The black rectangles are the two losing trades.

That being said, the signal given by the Up/Up indicator last Monday was a bullish one and a long position would have been established on Tuesday opening at 118.10 on the SPY.  The target date for this initial holding period is April 13, 2011, which is 120 trading days from October 26, 2010, including the initiation date.

Now I am very excited that this has happened again, but I am struggling to take the position because I am not particularly bullish going into the elections tomorrow and the Fed meeting on Wednesday.  Nonetheless, I am going to have to nibble at the SPY on pull backs below 118.10.
Ed Pawelec signature
Ed Pawelec
Contributing Editor
Price Shock Trader
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