Sunday, January 20, 2008
Solution to the Trading Puzzle
A week ago I put up a "Trading Puzzle" on the blog, asking what simple strategies resulted in the blue and green equity curves. Today, I reveal the answer. I'm disappointed I didn't get any comments, as I know a lot of people looked at this post. OK, so the blue line is what happens with a stop loss order set at a 1.25% daily decline in the index. In other words, you stay long unless the index is down 1.25% on the day. When a 1.25% down move is hit you get out of the market till the next day. The green strategy is the same except that instead of getting out of the market you get short once the market is down 1.25% on the day. It's amazing how much difference this simple strategy that involves no attempt to predict market direction made this year. Stops can be important.
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2 comments:
Hello,
Did you use intraday data to simulate the results from the stop-loss? Or do you asume continuity?
And why 1.25%? Why not 1%? Or 1.5%?
Good job anyway!
Hi Qi
The futures markets are pretty continuous except over the weekend (which I didn't take into account) and brief closed periods in the early evening which again I didn't take into account. I just used high, low and close data. So for example if the low of the day was a 1.5% move from the previous close then the stop was hit. If the market then closed say at 1.5% down, this day would see a 1.25% loss only for the stop only model, for the stop and reverse model it would see a 1% decline only. The big thing I assumed away was that the overnight futures didn't trade lower than the daytime futures. So it wasn't possible to hit the stop overnight but for the market never to trade down there during the day. In most cases this wouldn't make a big difference.
I chose 1.25% because that was the best stop (in terms of maximizing the Sharpe Ratio) in my existing trading model.
The point of the exercise was to show how a totally mechanical stop algorithm can generate excess returns and alpha. It's probably the secret behind most trading systems.
I've been taking this idea further in more simulations....
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