Buying on the Dips in your Strategy

Wed, Sep 22, 2010 | Jared Woodard

Options Education, Studies

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.]

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8 Comments For This Post

  1. JD BEAR Says:

    I agree that trading emotionally is expensive.

    However, one cannot generalize from the properties of one system to all systems. A daytrading system that I use tends to experience runs of losses. It is best with that system to wait until it starts showing profits before increasing size.

  2. Jared Says:

    JD: Certainly. That’s my primary concern – to see traders tracking the performance of their strategies so that they know when it actually makes sense to increase or decrease exposure.

  3. Jeff P Says:

    Excellent inspirational post Jared.

  4. JensK Says:

    Great post!

  5. Global 34 Says:

    Great call. This is similar to the aggressive strategy I use with 3x ETFs. Some of the concepts can be credited to Trading-markets (dot)com, but the application and indicators are my own. I make my money when everyone else, but a few, are running away from the markets.
    good luck in your trading to all,

    Global 34

  6. Cyriac Says:

    Short iron butter fly works when markets are moving with in a resonable range.Its holding period is very long and chances of getting a bigger move during the holding period are very high.As we are selling out of money puts and calls and buying far out of money calls and puts, there is not much change in deltas.The maximum profits are also very low when compared to maximum loss.
    Even it is executed early in normal markets profits may be very low.
    For example 106put on SPY is 0.31 and 107 put is 0.39 on 24-10-2010.With markets breaking out how can you decide on the upper side.117 call is 0.90 and 118 call is 0.58. Maximum losses can be around $0.5 The advantage low risk is imaginery.People who execute this strategy takes bigger positions using the available funds as margin.
    Markets may make a big move once in a while say twice a year.Whatever you say it is difficult to get out of an iron condor when markets make big moves beyond the break even points. The losses will wipe out all one made during the previous months.
    I am sure you also know all these.I do not know why you propagate this strategy like this. I have the misfortune of getting into trouble whenever I executed it. In May I had SPY 116-114,124-126 with volatility around 18.You know what happened.An increase in volatility to 80% appeared from now where.
    I write this because I want to make a discussion on these strategies where chances of once in a while failures are there.Cyriac Kandathil

  7. Jared Says:

    Cyriac, the bio on your site reads in part:

    “After years of experiments and failures he has developed a strategy that provides 30% returns annually on margins without any risk.”

    I’ll adopt a charitable interpretation, and assume that the bio was written by an overzealous web developer who didn’t know that claims of strategies offering market-crushing returns “without any risk” are a perennial and unfailing mark of charlatans everywhere.

  8. isomorphismes Says:

    You’re basing this argument on the premise that the strategy is fundamentally strong. But strategies can lose their edge or maybe they were lucky rather than principled and their luck has run out.

    Kelly Rule says to lever up only when you’re super confident. It doesn’t say when to be confident.

2 Trackbacks For This Post

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    [...] Returns from Your Strategy …by buying on the dips in the strategy returns.  So says an excellent recent post from Condor Options.  A strategy doesn’t necessarily work the same way as an individual [...]

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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