About last year I began dabbling in the stock market. Like most beginners I had no plan, no entry rules, no exit rules, no risk management and thought I could pick the direction of the market using logic and information. I also had no tools to help me filter through the hundreds of listed equities.
I was using around $10,000 per trade and looking back on it, it was simply gambling. I had a number of wins and a number of losses, but no systematic approach. This is where I discovered trend following via Nick Radge of The Chartist. I bought his book ‘Unholy Grails’ and consumed it, it actually made complete sense and the concept is brilliant. It’s nothing new, it’s not a magic bullet cash machine bullshit system as you might expect. Trend following has been around for decades and consistently makes profits.
First of all the book is focused on the ASX which is great, and it actually tells you what software to use and how to implement it. I won’t turn this into a book review, I suggest you research that yourself. I am going to explain my own approach based on the knowledge I have gained thus far.
The software I’m using is Amibroker. It takes a data feed from Premium Data on a daily basis. I have written the system code for Amibroker to run on the data and search for specific buy and sell signals based on simple price indicators.
The system code is using Nick Radge’s ‘Bollinger Band Breakout’ system, but rather than buying it from him I wrote my own version. When the price of an equity hits the top Bollinger band, it tells you to buy that stock. When it hits the lower band it tells you to sell. There are a number of additional filters including:
- A volume filter so you’re not buying illiquid stocks.
- A price filter so we’re focusing on lower priced stocks with higher volatility
- An index filter (more on this below)
There are 3 approaches to using the index filter that I have examined that utilize the XAO and a simple moving average.
Control - No index filtering
This acts as a control to compare the various index filtering methods. A backtest with no index filter, the system is fully exposed in shit markets.
Annual return 27.59%
Maximum drawdown 47.62%
The drawdown is intolerable in my opinion.
The first is a ‘kill switch’ which activates if the XAO begins to drop below the moving average, indicating a market that is trending down overall. The kill switch sells all existing positions you might have and will block all new buy signals. Based on my backtesting of the XAO from 1997-2013, I get the following results:
Annual return 27.79%
Maximum drawdown 19.10%
That is an amazing return with a very tolerable drawdown. The filter didn’t change the return but prevented major losses during the 2008 GFC for example. It simply waited it out.
The second approach is an index filter that rather than exiting positions straight away and blocking new positions, instead tightens our stop losses to be more conservative. It is of course possible for a stock to go up when the market overall is going down, so this system prevents the premature exit of profitable positions. The result is a higher return but with more risk.
Annual return 30.99%
Maximum drawdown 30.01%
The question is whether I can accept a 50% higher potential drawdown for a 10% increase in return.
A slightly more cavalier approach than 2, this does not use the index filter for entering positions. Even if the market is going down overall, it will still buy stocks that are potentially trending up. It still uses a tightened stop loss in the same way as approach 2.
Annual return 31.69%
Maximum drawdown 29.52%
I think approach 2 will be the way to go, I believe I can handle 30% drawdowns but who really knows until I start. I am going to continue experimenting and testing my system until I am satisfied with its robustness. I will post as I progress further.