Saturday, August 19, 2006

The Trend Is Your End Until You Bend, My Friend

In my recent Trading Markets article, I draw upon the excellent research of the Barchart site and track the performance of 12 technical trading systems in the S&P 500 (SPY) market. What I found was that, for the past two years, 11 of the 12 have been unprofitable--many of these unusually so. The system that buys upward readings in the 40-day Commodity Channel Index (and sells downward readings) was unprofitable 84% of the time, losing the equivalent of almost 260 S&P futures points during a bull market!

Trading a shorter time frame, with a system that tracks crossovers of dual channels around moving averages (8 and 10-day; buying moves above the upper channels; selling moves below the lower channels) results in more trades over the two-year period (101), with 28 winners and 73 losers. That particular effort resulted in the equivalent of over 200 lost S&P futures points since August, 2004.

Driving the point home, Barchart assembles all the systems into a single Trend Spotter system(recognizing that the various systems are buying strength and selling weakness). That system yielded 22 trades since 2004, with 6 winners and 16 losers. It also managed to lose the equivalent of over 200 ES points in a bull market. And that's a trend following methodology!

Now before the harpies of trend-following hell decide to descend upon my unworthy head, let me emphasize that I'm *not* saying that trend-following is a worthless methodology. Michael Covel and Ed Seykota, among many others, have written eloquently on the virtues of trend following. Rather, what I'm pointing out is that trend following has been disastrous in the S&P equity index market over the past two years. I attribute this, in part, to the rise of program trading/arbitrage which now accounts for over 50% of market volume, according to the excellent H.L Camp service. When an institution buys the S&P 500 Index futures, it doesn't at all necessarily mean that the institution is bullish. It could be simultaneously selling baskets of S&P stocks, or selling the ETF. Selling the futures when they're out of line with cash and the ETF helps restrain market trending at even the shortest time frames.

This article from my personal site illustrates how we have systematically lost trendiness in the S&P 500 index market over a period of many years. By no means is this a phenomenon limited to the past two years. Many, many formerly successful daytraders in Chicago failed to adapt to this major sea change.

So what's a momentum trader or trend follower to do?

Let's go back to Barchart and check out their Trend Spotter system for the emerging markets ETF (EEM). Lo and behold, we find that, since September, 2004, we've had 15 trend following trades, with 7 profitable. Over the two-year period the same system that lost over 200 ES points gained 14.50 EEM points or about 25%. Yes, that's below the return from buy and hold, but notice the difference with the SPY results.

Gold? If we track the GLD ETF, we find 8 of those 12 Barchart technical trading systems yielded profits.

Clearly, if you're going to buy strength and sell weakness, *what* you trade makes a world of difference. An informal rule that I've found useful: Look at the depth of the market order book for whatever you're trading. The deeper the trading instrument's book, the less likely it is to trend. We see very deep books in the fixed income futures markets and in the ES; less so in the Russell 2000 futures; less so still in the emerging markets.

Inexorably, however, hedge funds and other quantitative trading institutions are picking off the lower-hanging market fruit. With the vast expansion of ETFs, comes the opportunity for continued expansion of arbitrage and expanded liquidity of global markets (as exemplified by deeper order books). Already it is difficult to find any equity futures index/ETF that outperforms buy and hold on Barchart's systems. Which itself may point to a source of possible edge for traders able to fade the normal human tendency to extrapolate the recent past into the near-term future.