You've just read about good (as opposed to too-good-to-be-true) results on a new strategy, one that seems relatively easy to understand and implement. How do you go about deciding if that new trade strategy is for you?
We've talked about this previously on this Options 101 site. However, since some traders jump from trade to trade, it's reasonable to talk about it again, using different examples. This time, let's use a couple of examples from Stock Market Edges: A quantitative guide to developing winning trading strategies by Philip Reschke. I'm not familiar with Reschke and haven't previously followed his suggestions, so I am in the same boat as any of you who might have found a trade suggestion of his that you'd like to consider.
First, don't trust me or anyone else to tell you what Reschke or another market pundit suggests or why that suggestion is made. If you're intrigued by an idea, always go to the original source or do your own testing. Reschke believes that quants, those who trade based on extensive statistical testing of various algorithms, have an edge over those of us who trade differently. Although I have a smattering of knowledge of statistics, my college statistics classes were taken in the days before algorithms were applied to options trading by the big firms, much less by mom and pop retail traders. Are his test parameters satisfactory? To decide whether you believe Reschke's suggestions are good ones, you'd probably like to examine the evidence he presents in more depth than I can reveal in a single article, even if I were more highly trained in statistical analysis than I am.
Reschke makes several suggestions in Stock Market Edges, but the ones we'll examine are buying a new 15-day low and/or buying when RSI(14) is below 30. We'll touch on his conclusions when the trade was held for five days in each case. He tests these setup--and others, including holding for different time frames--on several markets. One that's familiar to all of us is the SPX 500 ETF, the SPY. Let's see if we can find a trade that meets these setup and entry parameters.
First, a little explanation is in order. I've used a Donchian channel setup to identify new 15-day lows. Donchian channels were first developed by Richard Donchian. He used these channels to find breakout trades. Reschke's tested trade does the opposite: he tested a long trade when prices are at a new 15-day low and he tested a long trade setup when RSI(14) is at or below 30. RSI is the relative strength indicator. He's fading the move in both cases.
While the RSI is a frequently utilized and familiar lower indicator available on most charting services, Donchian channels may not be. It's not offered on think-or-swim charts, for example. No worries. If you have basic programming skills, you can probably write the code and import it into your charting services. If you don't want to bother, a quick Internet search will probably soon locate code. For example, I found a code for think-or-swim written by Chris Ball, M.I.T. graduate, senior software engineer, blogger and YouTube presenter. In a matter of moments, I changed his default input length of 20 (days, intervals) and the color of his the channel lines he used, and imported the code into think-or-swim. If I can do it that quickly, with Fortran being the last programming language I learned, you can, too. Thanks, Chris Ball, for the code.
SPY Daily Chart with Donchian Channels and RSI (14):
Reschke warns that one drawback to some of these setups is that they don't occur often, and that's certainly true on this market. It turns out that we see both setups fulfilled at the same time in the two instances highlighted on the chart. Those are the only two instances in six months when the RSI setup is fulfilled, although there's an additional time when a new 15-day low is fulfilled. I didn't mark that setup in April on the chart. Buying that third instance in April and holding for five days clearly would have been a successful trade. Therefore, there are only three instances of new 15-day lows on this chart and two occasions when RSI(14) hits or goes lower than 30.
In the first case highlighted with blue ovals, it's questionable as to whether the RSI would have measured as low as 30 on January 23, when the first long red candle closed under the Donchian channels. Although it appears that it is now, that line can be dragged lower by subsequent days' drops in price. We would have had to have been looking at that chart that day to be certain. Let's assume that RSI(14) was at 30 or below, so that conditions for a long trade would have been fulfilled whether we were relying on the new 15-day low or the RSI(14) at 30 or below. Our purchase of 100 shares of SPY would have been at the open the next day, and we would have sold it at the close the fifth day. Ditto with the February 3 instance when the conditions for the trade were met, whichever setup was used. In April, the setup for a new 15-day low was met but not the RSI(14) setup.
Conditions Fulfilled on January 23:
100 shares x [178.18 (close on 1/31) - 179.06 (open on 1/27)] - $10.00 (two-way commissions) = -$98.00
Conditions Fulfilled on February 3:
100 shares x ($179.21 - $174.95) - $10.00 = +$416
Condition Fulfilled on April 11:
100 shares x ($187.04 - 182.93) - $10.00 = +$401
Slippage must also be factored in if you're going to thoroughly evaluate a trade. Reschke did include slippage in his statistical evaluations, although I did not in the above examples. The bid/ask spread for the very liquid SPY is often a tight one cent. If I were formally testing this strategy rather than just illustrating what we would be seeing when conditions were met, I'd be including at least $0.02/share x 100 shares two-way slippage in my calculations.
For whatever it's worth, Reschke also suggested that this trade was successful holding "even 10" days. In the first two instances pinpointed here, the trade would have been much more successful holding ten days, but in the third case, the trade would have been less so. We don't have a statistically significant number of trades, so we cannot draw conclusions from what we see here.
What should you, as a trader, be considering when you're evaluating whether you believe someone else's results and whether, even if you do, a new trade is a viable one for you? As Reschke warned, the conditions are not met often. Will this be a problem for you? Are you a trader who might enter these intermittently but then grow impatient and forego other instances when you're alerted that the conditions have been met? Algorithmic traders would warn you that you're not going to get the same results if you don't trade the signal whenever it occurs. For example, if you're cherry picking when you enter, you might choose an instance when the loss is bigger than you had hoped and then, out of discouragement, pass up the next destined-to-be-profitable trade.
Something else concerns me personally more than infrequency of the signals here. This trade tested trading shares of SPY, not options on SPY. Therefore, we're putting $17,828 (including $10 in two-way commissions but no slippage) at risk in the first trade, $17,505 in the second, and $18,303 in the third. We options traders are used to getting more leverage for our trades. Reschke's tables suggests that the average return on a long trade entered after a new 15-day low and held for five days is 0.486 percent. His calculated result for buying when RSI(14) is at 30 or below and holding for five days jumps to 1.684 percent. Both results are well above the less-than 0.10 percent average return of the total market for those days, and do include both slippage and commissions, but some traders will not have the funds available to commit more than $18,000 to a trade in the expectations of an average 0.486 or 1.684 percent return.
Can we increase the return by combining the signals? Maybe, but we can't assume that without testing. Perhaps Reschke combines the two setups later in the book. Can we achieve the same result by trading DITM SPY options? Maybe, but again we can't assume that. So, what does a trader do if intrigued with the idea, sure that there's enough patience to wait for trade signals and confidence to keep taking them when they come?
If you're piqued by your initial look at a new setup such as this, examine all the information you can find on the trade. In this case, for example, it might be worth buying Reschke's Kindle book or waiting until it's free again to download it. If you're adept at setting up your own algorithms, you can set up your own test to determine if you agree with Reschke's conclusions or if you find a setup that suits you better. You might test meeting both conditions--the new 15-day low and the RSI(14) at 30 or below--or you might test buying a back-month DITM long call instead of SPY shares. You might test the same setup on a 15-minute chart, with an intention to hold the position through five 15-minute bars. I have no idea if those setups work: that's the point.
And if you don't have the ability to run such tests? Educate yourself enough to understand Reschke's premise and determine if you would have confidence in his conclusions. Then, you know what the next suggestion is going to be, don't you? Back test. Test in real time with simulated trades, adding in your best guess at slippage. If nothing else and if planning on buy SPY shares instead of options, go back several years on charts and just add up the profits and losses for the trades if bought at the open after a signal and closed on the fifth day once a setup occurred. That won't, of course, give you any idea of how well an options trade would perform.
Be curious. Be interested in other trades, but don't automatically believe what someone else tells you, even someone who sounds erudite and can throw up lots of tables and statistics. Make sure you understand the limitations of a trade. Don't consider a trade setup if you know those limitations will prove problematic for you, no matter how intriguing the trade's results appear. Test, in whatever way you can test, and of course start small if you decide to go forward with a new strategy.