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TradingMarkets.com
What Doesn't Work On Wall Street
Monday July 14, 8:53 am ET
By Larry Connors


Trading Thoughts and Research For A Relaxing Summer Weekend...
This weekend I want us to look at some various thoughts and ideas I have to help you further your path to successful trading.

There Are Systems And Then There Are Systems

I've always been a big believer in using mechanical entries with somewhat mechanical exits as a way to trade. As I've mentioned over and over, I'll let the guys who like to guess do what they do. For me, I need statistical evidence that something works, and, just as importantly, I only want to trade strategies that make sense. They need to be strategies that are trading an inherent market condition in order to better assure they'll work in years to come (there's never any guarantees to any of this but again, in my opinion, it's a far better way to trade vs. guessing).

In the trading world, lore becomes reality for many traders. Unfortunately, the lore usually does not pan out. Let's together look at a few of these fables:

Here's One Club You Don't Want To Join!

Buy the market (CBOE^SPXNews) when it crosses its X-day moving average. Sell short when it crosses below:

Makes sense, doesn't it? We read all the time that something is crossing above/below its moving average and therefore we should enter/exit the trade. Right? Well let's look at the S&P 500 cash market over the past 30 years and see what the results would have been had we done this. What percentage of the trades were profitable? Well, if you bought the market when it crossed above its 50-day moving average, and you sold it short when it crossed below, you were correct a whopping 22% of the time. Go to the 100 day ma? You were right 19% of the time. Go to the Holy Grail 200-day MA? You lose again. You were right even less...17% of the time. The 100-day MA lost money and the 200-day made some money, but you were far better off just buying and holding, something that only works when you have an upside bias, like we've had for most of the past 30 years.

More lore? Let's look at overbought and oversold indicators. Let's use the good 'ole 14 period RSI indicator and use the default parameters all the software programs give us (in other words, for this one we'll join the Default Parameters Trader's Club. At an RSI reading of 70 (overbought, according to the Club rules) we'll sell the market and we'll go long when we hit the oversold number of 30. Makes sense, right? We all learned this early on in our club initiation days. Let's think about it. Buy when the market is oversold, sell when it's overbought? Real genius. You should be able to buy your own island with this! And, guess what...you're right more than you're wrong. It's been correct 55% of the time since 1973. The only problem is: you still lost money. You lost 77 S&P points in 30 years. Overbought many times became more overbought as the market rose during this period of time.

Let's look at one more. Breakouts. Let's look at when the market makes 20-day new highs and we'll short it at 20-day new lows. I will tell you that a variation of this method does work in the futures markets. The "Turtles" and other trend-following funds have proven that. They experience large drawdowns, but over time they have made it successful. But, in the stock market it doesn't hold, as you will see. Giant upward moves over the past 30 years in stock prices should have gotten you long for a good portion of this trend. Yet you lost money here, you were unprofitable in 2 out of every 3 trades, and you lost money 16 out of the past 31 years!

Three methods that permeate Wall Street and three methods, as measured above, that have absolutely no edge to them when you look at them statistically.

Let's Keep Going...

Some further thoughts on the above:

1. This does not mean that moving averages, RSI or breakouts do not work. I trade stocks in the same direction as moving averages so at least in my mind, there is validity to them. What there is no validity to is the fact that, at least looking back, you will make money from them because that day they crossed a "magical line."

2.You can probably "optimize" the above numbers and make something work. My guess is that it will not hold up long term.

3. Lore is lore unless you can statistically back it up. And even then, there is no guarantee it will work in the future.

4. Most of the tests made money on the long side (and lost on the short side). One can delude themselves into believing they'll only take a long trade and ignore the sells. But, the S&Ps were at 119 in 1973, They've increased eight-fold since then. There's been a built-in upward bias, something no one knows will continue in the future.

Will you now trade any of the above methods in the future? I hope not.

What Works?

Many, many things. And I'll give you a simple one you've never seen before. Here are the rules, and then I'll explain the thinking behind the rules.

For Buys (sells are reversed):

1. Today the VIX closes 5% above its 10-period moving average.

2. The LOW of the VIX today must have been BELOW its 10-period moving average. Also, we won't take any sell signals if the VIX is above its 100-day moving average.

3. Buy the S&Ps on the close.

4. Exit the S&Ps on the close when they cross their 10-period moving average.

The whys of the rules:

1. The VIX closing 5% above its 10-period moving average tells us the market is likely becoming oversold (if you need more information on understanding this, I've written a and done a course on it. You can find them in TradersGalleria.com.

2 & 3. The low of the VIX today being below its 10-period MA tells us that the market was likely in some sort of uptrend and that by closing 5% above its 10-period MA, we got a very sharp pullback today.

Why do we have the 100-day rule for sells (you can get nearly the same results if you just don't take any sell signals if the VIX is above 40)? The 100-day rule (or the less-preferred VIX 40 rule) is used to reflect the fact that extremely oversold conditions snap back sharply (think July 2002, think post 9/11, etc.) and many times will appear short-term overbought when in fact they still have a long way to run. Simply stated, an oversold stock market most times trades very differently than an overbought stock market.

4. Exiting on the opposite side of the moving average tells us the pullback and subsequent rally (or selloff) is likely near completion.

Real simple. Basic market realities that have occurred before any of us were born and will likely be around long after any of us are still here.

Let's Look At The Results Since The Intraday VIX Data Has Been Published In 1993 (Up Through Thursday):

1. It has made money every year over the past decade (that's very good).

2. 69% of the signals were correct and the Profit Factor is 2.68 (also very, very good)

3. Despite the strong upward bias in the market, it's been profitable on the short side (it's very important to have a method that has made money on both sides of the market, especially over the past decade)

4. It trades about once a month, you would have been in the market less than 25% of the time and it has made over 960 S&P points (all very good).

A nice system for you to add to your repertoire.

I'll Leave You With These Final Thoughts

Even though it's good to have a new system available for your trading, the more important lesson this week is that you shouldn't take lore for granted...no matter how long it's been around. You must look deeper into things and, if possible, statistically prove them. The obvious is usually not workable. Buying when something crosses above or below a "magical" moving average has no validity to it magical number crossovers don't make money, yet they're talked about all the time. The above statistics help bring this out.

Have a great week trading (and the next time someone tells you a stock has crossed its 100-day moving average and therefore it's a good buy, you know he's probably a member of the Default Parameters Trader's Club

Larry Connors