Ice Station Zebra

A personal blog on science, health, business, interesting people and stock trading.

Why trend following should work

I explained how I intend to implement a trend following system, but I haven’t explained why it should work. The system does not try to pick winners. If it did, it would be no more trustworthy than a lottery system that guarantees you will win millions of dollars. Most trading systems use various indicators, complex algorithms and patterns to determine whether a stock is about to go up or down. As far as I am concerned this is impossible for the average trader and is nothing but a distraction from the only true indicator which is price. 

Trend following has a win rate of around 50%. It gets it wrong half the time!

Picture a random stock and a graph of its price. Let’s assume it appears to be going up, and you buy in. It’s a 50\50 chance it will continue going up, but if it keeps going up the potential increase in price is unlimited. If it goes down, the potential loss is controlled by you, and is generally around 2% of your equity. Can you see how this makes money now? It’s a coin flip whether it goes up or down, but you control how much you lose by using a stop loss, and have unlimited upward potential. That’s the ‘positive expectancy’.

It seems obvious now, but I think the vast majority of beginners do not see it like this. When I first tried trading I was buying stocks when they were going down because I thought they were about to go up again!

ASX Trend Following

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.

Approach 1

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.

Approach 2

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.

Approach 3

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%

Conclusion

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.

The Wisdom of Steve Jobs

I was never a big fan of Apple, being a staunch Windows user. Nevertheless, after watching numerous interviews with Steve Jobs, I started to realise that he is a very interesting man to listen to. Take this clip for example.

Preventing Cancer

I hate even typing the word ”cancer”. So many people have been prematurely removed from existence by it. Richard Feynman, Steve Jobs and Frank Zappa to name a few famous folks that are dear to me.

I spend a lot of time researching the prevention of cancer because it scares the life out of me. There are new studies coming out every single day with conclusions such as ‘drinking green tea can reduce your risk of cancer by x%’. I do pay attention to these, but I think there is something bigger, something more powerful we can do.

Based on my research into the research being done (I only read clinical studies), fasting has the potential to be one of the most powerful methods of prevention, and maybe even assist in treatment.

Fasting triggers a cellular process named autophagy.

Autophagy in the Pathogenesis of Disease

http://www.sciencedirect.com/science/article/pii/S0092867407016856

In simple terms, autophagy is when the cells in our body begin digesting junk within the cell because they are starving. This junk includes mis-folded proteins and damaged organelles, things that lead to cancer, neurodegeneration and aging. I am going to focus on the cancer aspect in this post, but it has far-reaching effects other than that.

So do regular periods of fasting, and therefore autophagy and reduced IGF-1, prevent cancer? The studies are leaning towards a yes.

If you think about it, our particular species has been evolving for around 200,000 years. Over those 200,000 we never had constant access to food. Early humans didn’t eat 3 meals a day, they might have a big catch one day and nothing the next 2 days. It’s only within the past few hundred years that we have this mentality that you must eat breakfast, lunch and dinner.

Our bodies never evolved to handle the constant intake of energy. They evolved to be opportunistic, when food was available it used the energy to divide and grow new cells, when food was scarce it locked things down and used the time to clean out the cellular junk and undertake maintenance. When our cells never get a chance to repair themselves, the evidence shows this results in an increased risk of cancer, neurodegeneration, heart disease and accelerated aging. I am going to post further information with clinical study references soon.

Richard Feynman

One of the most fascinating human beings I know of. He is a Nobel laureate, and one of the greatest physicists that ever lived. He has an amazing sense of wonder, kindness and happiness that I aspire to, and can only hope to achieve. He can turn the most mundane of physical phenomena and explain the amazing reality beneath it. Take his explanation of how rubber bands work, for example.

It is curious that physical courage should be so common in the world and moral courage so rare.

—Mark Twain. You only have to walk around Melbourne’s CBD late on a Friday night to see the truth in this quote.

Why does everyone love property investing?

Looking at ABS statistics from 20 odd years ago, the median price of a house in Australia was 3x more than the median salary. Today that gap has increased to 8x. Property is at the point where it’s nearly out of reach for the majority of Australians unless they’re married and have a dual income. A great investment if you were a baby boomer.

I’m 26, and a number of my friends have either already purchased investment property or are at least planning to do it. They’ve been pushed by their parents for the most part. The parents don’t realise that they bought their property at the golden time, buying now at the peak of a bubble is a disaster waiting to happen. If it starts to turn sour you’re stuck with it, along with a massive mortgage. 

Most investment properties today are negative-geared, meaning there is a net loss on the rental yield minus the mortgage repayments. This can be useful in specific situations, but the tax benefits are overrated. So if an investment property is negative-geared at the moment when the interest rates are at record lows (about 5%), what happens when the interest rates inevitably go up? Can they handle a 10% interest rate?

What’s the exit strategy? Sell the house when it gets too tough? You can’t do that otherwise the entire investment was pointless. You are tied to it for upward of 30 years, hoping the market will continue to climb, when it most certainly is inflating at a rate beyond which Australian’s can keep up with.

I have decided to invest in the share market instead. When the market begins to contract, I can revert back to cash and wait it out while I earn some nice interest in my bank account. Try that with property.

High protein diets.

It was after watching the BBC Horizon documentary 'Eat, Fast and Live Longer' that I began my journey into longevity research.

The documentary featured an Italian professor named Valter Longo. He explained his research into the effects of insulin-like growth factor (IGF-1) on the human body, IGF-1 is the hormone that pushes the cells in our body to divide and grow.

By forcing our cells into a constant state of growth and division, we increase the chance of genetic errors and build up the junk within our cells. The analogy he used was that it’s like driving your car with your foot to the floor and never stopping at a mechanic. This apparently leads to an increased risk of cancer, diabetes, heart disease, neurological disorders such as Alzheimer’s, Parkinson’s disease and general accelerated aging.

One may ask what significantly increases the level of IGF-1 in our bloodstreams? Well it turns out it is the golden supplement of the health and fitness industry, protein. Protein levels are directly correlated with the level of IGF-1 in our bodies. If you eat a high protein diet, you very likely have high levels of IGF-1. It’s great to build muscle, but apparently detrimental in almost every other way.

What action significantly reduces IGF-1 besides a low protein diet? fasting. It reduced it by about 40% in the host of the documentary. The key to improving our long term health might not simply be eating healthy and staying fit. Periods of not eating might be just as important.

When the level of IGF-1 is reduced, instead of our cells being in a constant high gear of division and growth, they enter a protective stress resistance mode and begin repairing themselves because it is more energy efficient during times of stress, which in this situation is a lack of food. The repair process is called autophagy. It does not occur to the same degree under normal circumstances. Fascinating stuff, don’t you think?

I have a lot more to write about this.