Last week’s newsletter dove head first into the explanation pool about “Pair’s Trading.”
It started by comparing System Pairs Trading to sector rotation with the difference being this system will rotate between indexes within a single strategy, not between sectors.
The newsletter left you dangling with two charts.
Just to Quickly Review
I posted an equity curve with its drawdowns depicted as a blue isosceles triangle in the lower panel. The first chart was the Large Cap Margin algorithm pulling possible signals from the SP500 only.
The second chart was the Large Cap Margin algorithm pulling possible signals from the NDX 100 only.
Here are those two charts.
SP500 with Drawdowns
NDX 100 with Drawdowns
Like slowly walking a Stairway to Heaven, (for all you Led Zeppelin fans) we are gradually and purposefully stepping through the explanation of this type of trading one stair at a time.
Relative Strength
The next step is to put those two above equity curves on a relative strength chart so we can readily see when the SPX is stronger compared to NDX and vice versa.
For those of you who want to get clarity on what I mean by Relative Strength with this system, here is some reading for you.
The top panel is the algo using the SPX, middle panel the NDX and the bottom is the relative strength of two upper panels.
The blue mountains are when the SPX is stronger relative to the NDX. The green is where the NDX is stronger relative to the SPX. As it changes from green to blue and back again, the universe from which the algo generates signals will rotate from the SPX to the NDX and back again.
We’re almost there, so stick with me (I know we’re all singing “Stairway to Heaven).
The next step is to take the bottom panel of the above chart and present it as an equity curve.
I will not bore you with the plethora of settings you can tweak and twerk but to let you know I’ve taken the liberty and defined three scenarios for you.
A Fast Turnover – where the rotation will be responsive to market changes but endure churning (just like all indicators isn’t it?)
A Medium Turnover – where the rotation will be less responsive to market changes but less churning
A Slow Turnover – where the rotation will be the least responsive to market changes but the least churning.
Fast Turnover
Medium Turnover
Slow Turnover
Can you see the times the strategy would rotate from one index to another? How one would produce less churning but rotate slower?
Almost There
Now it is time to take all these equity curves and put them on one chart and look at the metrics.
Don’t blink, we’re just getting to the good stuff! Almost to heaven.
This chart is fairly daunting at first blush so I’ll break it down.
This chart has equity curves for:
1. SPY – Black (I put it there for reference)
2. Large Cap Margin pulling from SPX – Red
3. Large Cap Margin pulling from NDX – Blue
4. The Fast turnover from above – Dark Green
5. The Medium turnover from above – Violet
6. The Slow turnover from above – Bright Green
Take note this chart has been anchored on 12/1/2012 to April 23, 2018.
Here is a close-up of the Metrics.
Which one would you pick? I would probably dropkick the SLOW Turnover because the CAR and MDD ratio (MDD/CAR) is 0.52, whereas the medium and fast are 0.37 and 0.34 respectively.
Based on what I’ve shown you here and many other factors that would take much too long to put into a newsletter, I’ve chosen the Medium Rotation for the Large Cap Margin Portfolio. I will go through this process for each of the Large Cap Portoflios and determine:
1. If rotation is worthwhile and, if so
2. Which indexes then
3. Fast, Medium or Slow Rotation
One last point. This will all happen behind the scene so there is no need for you to do anything. The rotation we’ll do in the System’s Pair Trading will be on my shoulders but it’s important you know what I’m doing and why I’m doing it.
And that dear readers is how I spend my time.
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
“If awesome were inches, we’d be the Effiel Tower.”
