This would be one of those years where the "sell in May and go away" proverb was very effective.  For whatever reason, the "rule" has become less and less effective in recent decades.  If you take the rule since the beginning of the Dow, it looks like a rule you should certainly follow.  Slice that backtest into something more recent and it looks random at best.  This may be evidence of one of the oldest trading systems getting discovered and fading away.

But regardless of that, if you did sell in May this year, you missed out on a 15.36% (1969 point) decline on the Dow.  The Nasdaq did better only shedding 7.2% or 161 points.  And as we've seen recently, 161 points is a daily gyration for the Nasdaq <grin>.  Finally, our well diversified friend, the S&P 500 lost an even 11.0%. Ready for a real kick in the pants though?  The small cap Russell 2000 gained 2.2% since May 1st.

What does this mean?  Typically larger cycles (i.e. bull to bear, back to bull) have sector subcycles and then of course, smaller sector subcycles within.  But as I mentioned in a post earlier this year, large caps had been outperforming small caps for over a year and growth had been outperforming value.  This is backwards from the norm, but totally in line with the end of a bull and beginning of a bear.  Most speculate that this is because people start getting defensive.  So they hang up their high flying small cap for a GE, CPB or WMT.  This inflates the price of the stalwarts. This usually marks the beginning of the end of the bull cycle.  Smalls have already been underperforming, but they get taken out to the toolshed for another shellacking.  Then the stalwarts start to crumble as fear sets in.  Then quietly as the big boys are free falling, the VIX makes multi year highs, bankruptcies follow, unemployment shoots up, growth stalls or goes negative ... small caps start to get a bid.  Before the major averages pull out of the tail spin, small caps are showing gains.  This usually gives birth to the new bull.

So is it different this time? 

There's no doubt at some point we'll hear someone talk about how the word for danger and opportunity are the same in Chinese.  I don't even know if that's true or not, but we are getting a long term discount.  Think about if you bought stock when the Dow was at 14K.  You'd be off a good bit by now.  I'm not saying wait to buy stock until things look really ugly because you'd most likely be missing out on some of the bigger runs.  But when the opportunity presents itself, there's no reason not to take advantage of it.  Is now the time to buy?  I don't know, that's up to you.  Maybe you're the type of person that likes to see an uptick or two, the clouds parting a bit before jumping in.  That's probably pretty sound.  For me, I never know the difference between an uptick and a head fake, so I like to buy on the way down and sell on the way up.

I'll share some positions I took yesterday for discussion when the smoke clears.  But let's just say that the plunge in GE over the last two sessions was too much to resist :) 

My IBD this weekend tells me we're now in a confirmed rally.  I was questioning that just as recent as last weekend.  Apparently Tuesday was the follow through day they've been waiting for.

In the meantime, the non-complaint momentum fund I set up outperformed this week (up 1%).  <laugh!>.  With only three stocks in the fund, I'd say that was pure luck.  To recap, I'm currently holding ICLR, HP and HIL.  I have a new member to add to the mix on Monday, CF.  The stock has been on a tear over the last 12 months, nearly tripling in price.  I'm looking to catch the next leg up.  It closed at 162.54 on Friday.  Assuming I get about the same entry on Monday, I hope to ride it to somewhere around 187-188 or lose it somewhere around 145.

Right now, according to Marketocracy, my fund is not compliant.  The rules for compliance are:

1. You cannot purchase a stock so that it will increase your position to over 25% of your portfolio‘s value. If you violate this rule, your fund's effective inception date will be reset to the date that you bring the find back into compliance with all compliance rules, not just the 25% rule.
2. If a sub-25% position rises in value above the 25% threshold (without additional purchases), your fund will be out of compliance until you sell of enough to bring it below the threshold. (However, your inception date will not be reset.)
3. You may only hold up to 35% if your portfolio‘s value in cash. The other 65% (or more) must be invested in stocks. Real fund managers are paid to invest, not hold cash, and so the SEC requires that they meet this cash rule — hence we also require you to follow this rule a majority (51% or more) of the time.
4. Half of your long portfolio may be in positions that may not exceed 25% of the value your total portfolio value. That means that you can have two 25% positions taking up that entire half of the portfolio, or, you can have five 10% positions (since none exceed 25%).
5. The other half of your long portfolio may be in positions that may not exceed 10% of the value your total portfolio value. At the least, this means that you would need to hold 5 long positions worth 10% each. However, you can (and likely will) hold a few more positions to make sure you have some breathing room below the 10% threshold.
6. Negative cash balances may not exceed 5% of total portfolio value. If this happens for more than 7 days per quarter, you are out of compliance. That means that you may not spend more cash than you have to buy stock — or in other words, you may not use margin.

I'm clearly in violation of item 3.  I only have one open position right now.  Ideally, I'd like to keep the portfolio around 12-15 stocks and the rest (if any is left) in cash.  However, it's going to take some time for me to get there.  These stocks are wild and I've already bought and sold 2 positions (ZEUS, stop loss and AXYS, profit target).  I may extended the profit target and stop loss ranges if things get crazier.

The sole holindg of the fund right now is ICLR, which is currently down about 3%.  This morning, I'll be adding two more holdings.  HP and HIL have been flagged.  I'm going to open positions roughly 7-8% of the total portfolio's value.

I have reason to believe that there is some merit to the "cut your losses early, let your winners run" in the momentum situation.  Basically, I'm up against some serious volatility.  I'm going to get about this two ways, the first way, I'm going to stick to relatively strict profit targets and stop losses.  I will revisit positions at least once a week if not more frequently.  When I see a position that has a loss of more than 8%, I'm going to sell that position and replace it based on my scan criteria.  I am also going to set a profit target double that of my stop loss, so between 14-16%.  I reviewed ZEUS and AXYS this morning, ZEUS is down 8% and I've submitted a sell order. AXYS went to the moon based on  wonderful figures.  I've submitted a profit target ~15%.

I'm also experimenting to see how much I will have to manage this.  I don't have a lot of free time these days, so a daily review is unrealistic.  Also, I don't want to over manage it.  8% may not be enough wiggle room to let these picks make their upside moves.  However, I don't want to sit there and wait while something is dropping like a rock.

This is still paper money and until I have the "~" worked out one way or the other, it will stay at paper money or with no money at all.

You'll be able to see how the performance is at marketocracy by clicking here.

I have a pretty good grasp on mean reversion type trading.  It's the cornerstone of most of my trading systems and typically what I use real money to trade with.  One thing I've never gotten the handle of is momentum trading.  My take is that mean reversion is great for vascillating markets.  Momentum trading is great in trending markets, particularly those trending up.  I've come up with some ideas over the last several weeks that I'd like to try.  I'd tell you more about them, but this is really throwing stuff on the wall to see what sticks.  I'll be refining this technique over the next several months, or I'll be throwing it away and going back to the drawing board.

To me, the key to momentum investing is trying not to get slaughtered during down trends.  I'm purposely starting right now (even though it's a little premature in my studies) because of the wild market conditions.  You'll be able to monitor my progress at Marketocracy and right now this is only paper money.  The MMF fund will start today with a NAV of $10.00 per share or $1,000,000 in cash.  No pretty pictures or graphs yet, however, the first buys will start today.  The two I'm starting the fund with are ZEUS and AXYS.

What's going to make this fund different for me is that there is going to be some discretion regarding which items I buy and sell and when I buy and sell them.  Typically in the past, I would generate a culled list from a series of fundamental and technical criteria and blindly buy and sell at periods defined in my plan.  This time, I'll rely on the noodle just a little bit to try and keep the fund out of danger.  Hopefully most of the screening and analysis will keep me out of serious danger.

Depending on the level of interest, I may keep the trade log public and rationale behind each buy and sell.

A couple of months ago I was talking about one trade per symbol in your trading system.  It was difficult for me to think that major components of major indexes could be at serious risk when I first began developing trading systems.  It's always hard to look at a GE, a Microsoft or even the largest auto maker in the world, GM as falling 50, 60, 75% or more over the course of just a few months.  I just want to point out that it does happen and is happening now.

One of my trading systems trades the Dow components individually.  It flagged GM, naturally, as a mean reversion candidate.  This happened in May (about the time I wrote the first article) when GM was around $20 per share.  We know how the story goes from there.  GM was trading as little as $9 this week.  That's a hell of a drawdown especially if you were averaging down the whole way.  Not to say that GM won't bounce back, because I don't know, but if you started buying @ 20 and kept adding to the position, you either have nerves of steel or you're sweating bullets.

After I wrote the previous article, I've been giving this a LITTLE more thought.  There are two things that seem to whack your profitability in trading systems.  One, limiting to one trade per symbol and two having stop losses.  However, both of these are vital to your long term viability.  I've discussed using option spreads instead of stop losses before and maybe this is an idea for getting exposure to a couple more trade signals on the same symbol.  Instead of buying more shares, consider buying plain calls or puts (not usually the best choice because IV is probably high and theta will chew you up) or buying an option spread such as a vertical or maybe a butterfly or calendar (if you really have a strong feeling about IV).  Now you can expose yourself to short term movement without the risk of blowout.

I'm going to explore this as my trade signals dictate.  With the market being as rocky as it is, I've had plenty of signals for the same symbol that I've ignored, or more aptly, RightEdge has ignored for me.

I have a limit order to pick up some PFE today.  The limit order was placed immediately at the open for $18.00.  PFE gapped up a little bit this morning and opened around $18.10.  I glanced at my delayed ticker which I have opened when I don't have IB cooking and saw a low of $17.96 posted.  Oh good, I got filled.  So I fired up IB to see my fill only to find the order still sticking out there.  Surely my little order would've been gobbled up with a low print of $17.96.  I checked a chart on IB and never did the line go lower than $18.03.

I've seen this happen before and sometimes it will stick and sometimes it gets corrected, sometimes days later.  The point to make here is that no matter what trading system you create, you're always susceptible to bad prints in back testing and even real time.  If my system posts a fill tomorrow, then my system is now out of sync with reality.  This is bad.

It's important to try and assess how bad this data problem will be.  I've been trading this system for quite some time and it happens to me once a month or so.  It's not enough to be bothered with, but is incredibly annoying.  For those that trade at a higher frequency, I expect this would be more prevalent.

And as usual, I don't recommend PFE.  Never follow anything I do.  This is for educational and analysis purposes only.

In part 1 of the series, I'll discuss the simplest of all option plays, going long a put or a call.  I'll outline the advantages and disadvantages of this simple strategy.

My interest in trading systems grew in tandem with my interest for options.  At various points throughout the years, I've focused on one more than another, but I've always kept the two in my mind.  While developing trading systems, I'd keep in mind how options could be applied.  And the same goes for looking at option strategies and how they might be applied to trading systems.  Allow for two quick examples.  If one were developing a trading system for thinly traded stocks or penny stocks, there is likely no possibility that this could be used with options.  If one is studying 4+ leg option strategies, there is likely no possibility that this could be used within a trading system since fills and spreads would probably kill a lot of your trading system's edge.  The good news is, trading systems like options typically do better in a high liquidity environment.  If you're getting bad fills in either options or within your trading system, it's very likely that your backtested results are not going to be anywhere near your trading account results.

Another lesson learned over the years is the effect bad data has on your testing results.  This can be somewhat mitigated by statements made in my previous post regarding mixing up your watchlist.  However, when reviewing your results you may notice some wildly profitable positions.  A clear signature of this is a windfall profit after a hold time of only one bar.  This is further established when you have a profit target and the position closes far above that target.  Typically in a trading system with profit targets based on daily data, your PT order will be submitted the next bar (day) after the system gets confirmation that the order was filled.  Of course, you can get a finer granularity of data and make this happen much quicker, but let's keep it simple because it can apply across the board.  Typically what happens is a rogue tick or just a plain wrong low/high print will trigger the backtesting engine to open a trade.  This will cause your position, when analyzed at the close, to show a massive, but erroneous profit.

Most modern backtesting tools (RightEdge included, of course), have the ability to specify how many open positions you'll allow per symbol.  While testing my systems, I typically like to allow a single open position per symbol.  The reason for this is that multiple open positions per symbol can skew your results and exacerbate survivorship bias.  Most are familiar with the term survivorship bias, but if you're not, I'll explain very briefly.  A trading system is already "cheating" because it's taking symbols of companies that currently exist.  In other words, merely surviving as a company is a big assumption you've made in your system.  You add to that risk by allowing open orders to pile on top of open orders.  With survivorship bias, we already know that today the company is alive and (hopefully) doing well.  However, in your backtesting, more than likely you've bought more and more as the company shares were plummetting and then at some point the whole thing was rescued and you were rewarded handsomely for the risk assumed.  This is represented in your phenomenal backtesting results.  Your backtest does not understand this risk, but you should.

Note: I've tried to get the bank accept my backtesting profits as deposits and they won't.

I've been working on a new trading system.  Since we're hard at work on RightEdge during the day, day trading is not really an option with a real account.  I've always enjoyed trading on daily data because of the pace.  I can always go back and analyze the trade in progress.  My goals for this system are:

• Relatively frequent trades.
• Manageable drawdown
• 1 position per symbol
• Low exposure per symbol

A few things I've learned over the years is how deadly curve fitting can be.  I've discussed this in the past but would like to reiterate some of my ways for getting around this.  Naturally, trading systems are curve fitted to a certain degree, otherwise they would be random.  However, what I'm trying to avoid is tailoring the curve to my particular watch list and/or time period.  To avoid that, I change watchlists frequently while developing, testing and optimizing the system.  As you tweak parameters, you should begin to notice some normal distribution of results.  For example, let's take a profit target.  Let's say you set a profit target as an optimization parameter and the value is 1% to 10% with a step of 1.  You'll likely notice that your winning percentage will go down as your profit parameter goes up and your net profit will likely form a bell curve of sorts if plotted where the profit target is X and the net profit is Y.  Hopefully, this type of pattern repeats itself to a certain degree as you change your watchlist.  Oh yes, and don't just change your watchlist, change your timeframe as well!  If your system has 70% winners, for example, it should hang pretty close to that for any time period you test.  If it's a long only system, it will likely do better in bulls and worse in bears.  This is an inevitability.

One of the traps I fell into years ago was developing a system (usually an extreme system) and then finding a watchlist that looked good with my system.  This was a great way to lose money, and I did!

Testing Your Trading System

It probably sounds obvious, but backtesting your system is just the beginning of your testing process.  The second phase of testing is executing it in real time market conditions.  If you're relatively new to executing systems live, I highly recommend you sign up for an account that has simulated trading.  Enter your orders (or have RightEdge do it) to your broker and let them get filled in real time.  Follow your account with simulation for some time and see if the simulation picks up trades or fills that didn't really happen.  This will hopefully identify the degree of error in data.  If you see one of these, be concerned, if you see several, abandon ship.  The last phase of testing is running it in a live account with real money, however, use about 1/10th the size that you will when you go into production.  Let's say you are going to allocate $10,000 for a trading system and you'll allocate no more than 10% per trade in production, or $1,000.  For testing, I highly recommend doing 10% of that, so each trade would be $100.  You'll likely lose small money on the commission, but that's a small price to pay for validating your system with real money.

Back to my trading system, I'm in the second phase of testing at this point.  I'll be testing over the next couple of weeks or more in a simulated account and then moving over to real money if everything pans out.  I'll keep you posted.