Tuesday, May 26, 2009

Short-Term Trends In The Stock Market Are Not Your Friends

I thought I'd quickly follow up on the "Why Short-Term Traders Lose Money" post that I recently linked via Twitter.

Data come from the excellent Barchart site: We're looking at the S&P 500 Index (SPY) going back to late 2003. Our system buys SPY if it closes above the two standard deviation Bollinger Band surrounding the 20-day moving average. The system sells SPY if it closes below that band. We exit the trade once the average moves back within the envelope defined by the upper and lower bands.

The logic of the system is that we wait for a significant trend--one that is a two or greater standard deviation move away from an average price--and then jump on board.

The average holding time per trade is 3 days. The system gave us 105 trades since late 2003. Of these trades, 70 were long and 35 were short.

Of the 70 long trades, 25 were profitable and 45 were unprofitable. Of the 35 short trades, 14 were profitable, 20 were unprofitable, and 1 was scratched. In all, the system gave us 39 winners out of 105 trades--about a 40% winning percentage. The gross P/L for the system (not including commissions or slippage) was -39.70 points, or almost 400 ES points. This is because the average size of the losing trades was larger than the average size of the winners.

I in no way suggest that this is an indictment of Bollinger Bands. On the contrary, they appear to be a decent starting point for a winning system if one trades against the trend. Rather, the lesson is that once a trend becomes "significant", it is already long in the tooth. If we simply follow human nature and extrapolate the recent past into the present, we will be well on our way toward losing money consistently.