If you’re trading a strategy with a long-term record of solid performance and a steadily rising equity curve, a great time to increase your exposure to that strategy is after the strategy has suffered a losing period. In other words, given a strong and consistent strategy, you should buy that strategy on the dips.
The thinking here is the same as it is for any buy-on-the-dips approach to investing in stocks. Because equities have tended to rise in value (in nominal terms) over the long run, it generally pays to buy stocks after they’ve experienced a drawdown. Similarly, for a strategy with long-term positive expectancy, the appropriate response to a drawdown is to increase exposure – not reduce or eliminate it – on the view that the performance of the strategy will revert to its mean. Conversely, one mark of a skittish, irrational investor is that he sells after a sizable decline. Individual stock investors are notoriously driven by emotion instead of information, but the same phenomenon occurs even among traders who are otherwise smart and fully committed to carefully researched, ruthlessly tested data-driven strategies. Instead of trading the strategy like a stock – reducing exposure after large gains are booked, and increasing exposure after the strategy has seen some losses, they do the opposite.
The chart below shows a daily mean reversion strategy (“Original Strategy”) that buys when yesterday closed lower and sells short when yesterday closed higher. Then, we look at three variations that track the 20-day simple moving average of the original strategy. When the equity curve of yesterday’s original strategy was below its simple moving average, “Panic” moves entirely to cash, waiting for the original strategy to rise above its moving average before stepping back in. “Frown” cuts its exposure by half when trading below the moving average, while “Think” actually commits 50% more capital whenever the original strategy is below the average.
data: Yahoo, Condor Options | click to enlarge
Panic, as you can see, is folly, and Frown(ing) also makes matters worse. It’s far better to commit more capital after the strategy has suffered a drawdown, betting that the performance of the original strategy will revert relatively quickly to its mean.
It is particularly and unpleasantly ironic when investors who are following a strategy based on mean reversion – whether it’s RSI(2), value investing, option selling, or whatever – fail to see the relevance of mean reversion for their own decision-making. A strategy that has performed well over the long run should never be abandoned after a decline unless there is overwhelming evidence that something about markets or the strategy has changed so fundamentally that the strategy will never work again. If I had a dime for every time I saw a trader abandon a strategy because they had evidence indicating that a fundamental change in the market meant the strategy would no longer work, I’d have no additional dimes.
Based on my own experiences mentoring and educating option traders, I think that the most important factor differentiating unsuccessful novices from those who survive long enough to become experts isn’t that the latter group knows more about the option Greeks, or is better able to analyze implied volatility, or anything like that. The decisive factor, as trite as it sounds, is that successful traders are willing to base decisions on information rather than emotion. Discretionary trading is, for virtually every human animal, an unprofitable path; but even a carefully planned, rigorously tested rule-based strategy offers absolutely no advantage if, ultimately, the application of that strategy is a slave to the whims of an emotional bag of organs. There’s a popular slogan in sports: “get your head in the game.” I’d venture to say that profitable trading is nearly synonymous with keeping our conflict-ridden, cognitively-biased irrational skulls as far from the game as possible.
[P. S. For any readers awaiting the next installment of the VXH series, I hope to have something available later this week.]