Does it Ever Pay to Go Short?

I did some tinkering with the model to avoid the kind of false buy signal that resulted in the stop out last week. I applied Hodrick-Prescott filtering to one of my indicators. This eliminates these kind of false turning points but also eliminates a fairly subjective rule in my decision tree. So, overall that improves the model. This is one step further to a fully objective system that can be automated.

You need to be careful with HP filtering as it uses all the data in computing the smoothed estimate. So in back testing you have to run the filter repeatedly using just the data that was known up to that point.

The model is currently short. But I don't have a trade on. I am thinking to put a trade on when it switches back to long.

In a recent post, I showed that a hedged portfolio levered 1.5 times would track the market when the market does well and track the model when the model does well. Instead of thinking of this as trading plus investment we can examine it as a pure trading strategy. That suggests that it doesn't pay to go short. Just stay out of the market when the model is short and only take the long trades and lever up the returns. In 2018 so far, going short would add to returns though. But in 2017 going short detracted from returns. The model only won 45% of trades in 2017. The average win (1.57%) was almost double the average loss (-0.9%) though so, the expected value of a trade was still 0.2%. When we split trades into long (22) and short trades (24) instead the average long trade made 0.83% and the average short trade lost 0.39%. So, avoiding short trades would have doubled returns, returning 20% instead of 10% for the year. Of course, just going long for the whole year would have returned 32%. But we don't know that will happen ex ante. Levering the 19% by 1.5 times or so reproduces the long-only result.

The question now is whether you can win by going long only in a year like 2008. My intuition is that trading would result in a positive return for the year but that this would be insufficient to hedge the losses in an investment portfolio. It would moderate the downside though.

Testing that hypothesis will have to wait a little while.

But for the moment, volatility is low and so going long only might pay off.