This week there were no position changes in the Sector Plus model. Our current three positions are SOXL, ERX, and DRN. To open next week, we will remain in those three ETFs.
The SPY closed the week essentially flat down -0.06%. The ETF Sector Plus model retraced from fresh highs down -1.95%. The ETF Sector Plus Strategy is up +36.87% year-to-date compared to its benchmark, the SPY, which is now up +6.03% year-to-date.
This Week’s Strategy Lesson: Designing A Strategy (Conclusion)
We are going to close out our “Designing A Strategy” series this week. We spent seven weeks going through the process we used for designing and testing our ETF strategies. We thought it would be useful to review those steps and go over some of the more important things we have learned.
1) Have a Core Trading Concept
The core trading concept is the fundamental building block that gives your strategy the initial edge. Whether it’s moving average crossovers, pivot stacks, phase changes, or any number of other trading ideas, the key thing is that it provides a higher probability setup for trading. For our models, we focused on ways to implement our unique method for calculating trend strength and ranking.
This strategy gets its edge from the finding and trading the longer term economic trends within sectors and countries. Even so, we don’t have a strategy, let alone a refined strategy, until we complete the following steps.
2) Define/Expand list of Trading Instruments
One of the key next steps is determining your “investible universe.” Sometimes your strategy determines this. We at MarketGauge use a lot of screeners to find stocks among thousands of potential stocks that fit our criteria. HotScans is a great product for this.
For the ETF strategies, we already determined the basic parameters: one strategy would be sector focused and the other would be country focused—and they both would include only ETFs. It still took some thought and testing to narrow that list down and answer questions like would we include leveraged funds or short exposure funds.
3) Money Management Rules
Money management is the set of rules, like capital allocation, trade frequency, and stops and targets that, when tuned properly, can turn a marginal strategy into a really strong strategy.
For our strategy, we wanted to tune it so that we would have the right level of concentration (we decided on three holdings) and pick up on the longer term trends. We recently added explicit stops and targets to both or our strategies. These are very liberal. They are designed to cap our max risk and get the most out or our trades without fundamentally altering the characteristics and performance of the strategies.
4) Create Rules To Avoid Bear Traps
Many strategies only work in particular market environments, either by design or because of a flaw. Traditional long only strategies work because the market tends to go up over time (due to both population growth and increasing productivity due to technological innovations), but they are also go down when the market has a pullback.
We specifically included short ETFs in our strategy and back-tested to make sure that the method we use for our trade signals would appropriately switch to short ETFs when the market is pulling back.
There is a lag between when the market starts pulling back and when we transition into the shorts, and of course, there are times where we make the transition and the market doesn’t follow-through, but including this in our strategy definitely improved our overall performance.
5) Calibrate your Indicators
At this stage in designing and testing a strategy, all variables are on the table. And it’s really the testing the interplay between the variables that makes that complicates this stage. Adjustments in one area can lead to vastly different results in another area. Data collection is important during this phase to help you determine what areas might be fruitful to look into further and what areas might be dead ends.
It is also important to determine the “robustness” of your variables. Ideally you would like to see similar results from the majority of your minor tweaking. If your strategy goes from the prince to the pauper with a minor change, you have probably stumbled upon a lucky coincidence in the market and not a repeatable phenomenon that you can bank upon in the future.
6) Diversification
The final key component we covered was diversification. It is one of the easiest ways to reduce the volatility of your strategy. Having multiple holdings/trades on at the same time reduces the impact of any single trade and averages out the results. You might not get the same return as non-diversified “hot” strategy, but no strategy stays hot forever, and you will get a proportionately higher return for your level of risk over any longer period of time.
I hope you have enjoyed this series and find the information interesting and potentially useful. We at MarketGauge are always observing markets and testing new ideas.
The Current Condition of the Model
For the Sector model, we remain in SOXL, ERX, and DRN. We had small pullbacks in all of them as the market moved off its highs, but they are each sitting on very nice gains.
I just wanted to note again that we are out of SOXL in the stops and targets model. While no one in the model has that entry, the total return from the position is about the same as if you had gotten in at that price and took profits along the way—just something to consider if you are going to use the stops and targets model.
No position changes are imminent in the sector model but stay tuned to the daily updates should there be any changes.
Here is a summary of the weekly performance of all the ETFs that the strategy monitors:
Best wishes for your trading,
James Kimball
Trader & Analyst
MarketGauge