0/91
1/3/91
1/4/90
–2.501/3/89
–100
ln(XAU/Gold)
Performance (1989=100)
200
CHAPTER 9 New Ideas of Markets
267
Performance of XOI and Crude Oil12.011.010.0300
XOI
9.08.07.0
200Crude Oil
6.05.0
ln(XO/Crude)
Perrformance (1989=100)
400
1004.0ln(XOI/Crude)
3.011/28/01
11/24/00
11/30/99
12/2/98
12/5/97
12/10/96
12/14/95
12/19/94
12/22/93
12/28/92
12/31/91
1/4/91
1/5/90
2.01/3/89
0
DateFIGURE
9.16
Performance of XOI and Crude Oil. Crude oil and oil refining stocks tend to move in similar directions.
human tendency to fight trends. This tendency might explain why trends occur instocks and futures. But the relative value spread markets we are studying in thischapter may not follow similar patterns since these markets are typically not in thepublic eye and only small pockets of traders track their movement. As a result, typical trend-following techniques may prove ineffective. In addition, the substitutioneffect might even suggest that movement away from a mean will quickly be corrected with a move back toward the mean.For example, when natural gas rises compared to heating oil, market priceswill cause changes in demand for each product. Natural gas will be replaced byheating oil and the relative prices will converge. If the Nasdaq 100 rallies versusthe S&P 500, rational valuations may cause investors to sell the overvaluedNasdaq 100 and buy the undervalued S&P 500. Countertrend and mean reversionstrategies could prove profitable when applied to these relative value markets.
APPLYING QUANTITATIVE TRADING STRATEGIES TO RELATIVE VALUE MARKETSSimilar to both the stock and futures tests, position sizes for our relative valuetrades are a function of the 100-day standard deviation of price changes.
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Market10 year yield minus 2 year yield5 year yield minus 2 year yield30 year yield minus 10 year yield10 year yield minus 0.5 2 year yield minus 0.530 year yield5 year swap spreadsYield to maturity of Merrill Lynch Master II Indexminus 5 year Treasury yieldsCBOE Volatility IndexNatural log of corn/wheatNatural log of soybeans/soybean oilNatural log of soybeans/soybean mealNatural log of gold/silverNatural log of S&P 500/Nasdaq 100Natural log of S&P 500/Russell 2000Natural log of Bear Stearns/Merrill LynchNatural log of CVS/WalgreenNatural log of Delta/AMR CorporationNatural log of Dupont/Dow ChemicalNatural log of Fannie Mae/Freddie MacNatural log of General Motors/FordNatural log of Coca Cola/PepsiNatural log of Motorola/Texas InstrumentsNatural log of Microsoft/IntelNatural log of Pfizer/MerckNatural log of Verizon/SBC CommunicationsNatural log of Wal-Mart/Home DepotNatural log of Exxon Mobil/British PetroleumNatural log of Royal Dutch/ShellNatural log of Unilever NV/Unilever PLCNatural log of PHLX Gold and Silver Index/GoldNatural log of AMEX Oil Index/Crude oilFIGURE
SectorYield Curve
Symbol2's-10's2's-5's10's-30's2-10-30 Fly
Credit Spreads
Swap spreadsHigh yield
VolatilityCommodity
VIXC/WS/BOS/SMGC/SLSPX/NDXSPX/RUTBSC/MERCVS/WAGDAL/AMRDD/DOWFNM/FREGM/FKO/PEPMOT/TXNMSFT/INTCPFE/MRKVZ/SBCWMT/HDXOM/BPRD/SCUN/ULXAU/GCXOI/CL
Stock indicesStock Pairs
Commodity vs. Stock
9.17
Table of Relative Value Markets. Thirty relative value markets are tested in our performance evaluation.
Position size = $10,000/100-day standard deviation of price changesWe test our stable of relative value markets on seven strategies:Channel breakout■ Dual moving average crossover■ Relative Strength Index■ Stochastics■ Momentum■ Difference from 100-day moving average■ Difference between 10- and 40-day moving averages■
The results are analyzed in a similar fashion to futures markets and stocks.
CHAPTER 9 New Ideas of Markets
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Channel BreakoutThe channel breakout is the first strategy we test on relative value markets. Longsare entered when a market’s close is the highest close of the past 40 days, andshorts entered when a market’s close is the lowest close of the past 40 days. Longsare exited if today’s close is the lowest of the past 20 days. Shorts are exited iftoday’s close is the highest of the past 20 days.The channel breakout produces profits in only 4 out of 12 years (Figures9.18a and 9.18b). Generally a losing strategy, some bright spots occur within credit spreads and stock index pairs trading. Performance on stock pairs is terrible,with only 2 out of 15 stock pairs generating profits over the 12-year test.
Dual Moving Average CrossoverWe use crosses of two moving averages for creating trading signals. A 10-day and40-day simple moving average is calculated every day. Long entries are established if the 10-day average crosses above the 40-day average. Short entries areestablished if the 10-day average crosses below the 40-day average.The chart in Figure 9.19 details moving average crossover signals applied tothe yield spread between two-year and 10-year Treasury notes. We see that theprice action is very choppy, and often our strategy buys at short-term highs andsells at short-term lows. Trend-following strategies such as this may not be idealfor relative value markets.Although performance of the moving average crossover is better than thechannel breakout, the results leave much to be desired (Figures 9.20a and9.20b). The moving average crossover produces profits in only 3 of the 12 yearstested. After making money in 1990 and 1991, the strategy has performed verypoorly since.
MomentumTesting a strategy utilizing 80-day momentum, long entries are established iftoday’s close is greater than the close 80 days ago, and short entries are establishedif today’s close is less than the close 80 days ago.The characteristics of trend-following strategies applied to relative valuemarkets is just what we would expect. Testing the 80-day momentum strategy, ourthird trend-following strategy, produces losses similar to the previous two strategies (Figures 9.21a and 9.21b). The 80-day momentum strategy generates profitsin the first two years of the test, followed by 10 consecutive years of losses.Volatility and stock pairs perform especially poorly. Only 2 of the 15 stock pairsgenerate profits.
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Trading Strategy Evaluation (Relative Value)40 day entry/20 day exit channel breakout40 day extreme for entry, 20 day extreme for exitEnter on a 40 day extreme close; exit on a 20 day extreme close1/1/1990-12/31/2001#Avg.Avg. Avg.Sharpe%Avg.Avg.Avg. Bars BarsofProfitMarketNet Profit K-ratio Ratio Max DD Trades Win hrs (000) Per Con. WinLoss Win Loss2's-10's697,032 0.08 0.37 –348,193 7243 341.592956,275 –25,243 46 17Yield2's-5's–317,922 –0.10 –0.20 –882,465 8330 459.40–848,557 –26,160 44 18Curve10's-30's400,654 0.04 0.21 –375,210 7338 559.59960,405 –29,609 51 162-10-30 Fly –722,476 –0.17 –0.44 –1,064,647 7929 553.36–20 40,633 –32,396 44 19Credit519.41367 37,105 –30,999 34 16Swap spreads 285,540 0.10 0.13 –572,460 85SpreadsHigh yield 1,768,775 0.16 0.67 –294,661 6641 161.84158 103,319 –28,290 54 21VIX–1,628,700 –0.71 –1.30 –1,773,840 93199.73–1,839 16,113 –26,066 39 18VolatilityCommodityC/W750,536 0.06 0.38 –424,125 6545 636.421869,836 –35,409 56 18S/BO112,712 0.06 0.06 –364,939 7236 1049.88157,432 –30,011 49 19S/SM–814,750 –0.22 –0.49 –961,890 7329 1333.42–841,212 –32,495 53 19GC/SL102,849 –0.02 0.07 –295,312 6935 938.70146,467 –23,814 49 22StockSPX/NDX869,133 0.06 0.47 –335,254 6244 1017.061472,199 –30,864 55 20IndicesSPX/RUT 1,352,171 0.36 0.69 –205,962 6551 1691.471173,721 –36,533 52 15StockBSC/MER –418,959 –0.21 –0.34 –659,156 8035 491.62–11 26,167 –22,524 38 21PairsCVS/WAG –372,849 –0.04 –0.27 –546,746 7831 505.19–940,985 –25,120 48 17DAL/AMR –471,833 –0.09 –0.31 –572,349 7734 694.36–943,710 –31,535 48 17DD/DOW –292,653 –0.06 –0.21 –559,222 7041 587.00–832,488 –30,507 46 20FNM/FRE –727,376 –0.20 –0.50 –951,299 8028 827.73–11 33,386 –25,061 43 20GM/F381,254 0.12 0.24 –191,862 7139 623.29749,038 –24,648 49 18KO/PEP–986,089 –0.19 –0.62 –1,050,492 7827 622.53–20 45,402 –34,027 49 18MOT/TXN –181,528 –0.05 –0.12 –535,688 7337 388.51–645,176 –30,462 47 19MSFT/INTC 322,765 0.10 0.20 –290,556 7139 434.071059,376 –31,158 51 22PFE/MRK –216,600 –0.05 –0.15 –556,517 7734 631.24–443,981 –26,601 50 17VZ/SBC –1,171,413 –0.75 –0.87 –1,259,964 8128 715.91–20 24,195 –29,924 40 21WMT/HD –675,580 –0.11 –0.47 –850,311 7431 522.40–18 31,014 –27,794 52 19XOM/BP –648,891 –0.19 –0.43 –917,971 7533 702.21–12 40,552 –33,073 51 18RD/SC–391,346 –0.26 –0.40 –553,540 8337 1393.80–419,629 –20,029 35 21UN/UL–834,987 –0.35 –0.94 –900,065 8726 1104.91–914,440 –18,513 36 21Commodity XAU/GC–661,754 –0.12 –0.48 –666,666 7432 555.89–16 31,647 –28,241 46 22vs. StockXOI/CL–275,158 –0.08 –0.17 –556,062 7232 666.77–643,097 –25,844 56 18Average –158,915 –0.09 –0.17 –650,581 7535 674.31–47 44,918 –28,432 47 194,000,0003,000,0002,000,0001,000,0000–1,000,000–2,000,000–3,000,000–4,000,000–5,000,000–6,000,000
Net Profit:Drawdown:K-ratio:
–4,767,443–8,234,652–0.16
Portfolio StatisticsSharpe ratio:Correlation to breakout:Correlation to 10-40 MA:
Dec-01
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Equity
Strategy Name:Parameters :Description :Run Dates :
–0.421.000.84
© 2002 Lars Kestner - All Rights Reserved
FIGURE
9.18a
Channel Breakout Strategy Applied to Relative Value Markets. The Channel Breakout Strategy does not generate profits onour relative value markets.
271
9.18b
1991
K-ratio0.550.34–0.650.010.06–0.54
1992
Sharpe Ratio1.880.94–1.80–0.610.42–1.39
1993
Year199619971998199920002001
1995
Year
Average Avg. Bars Avg. BarsLossWinLoss–28,35246174419–29,645–26,0663918–30,4325219–33,6985418–27,3984519–27,0435120Profitability Windows
1997
1998
2000
2001
© 2002 Lars Kestner - All Rights Reserved
1999
Num. ofNumber of Profitable PercentLength Windows Windows ProfitableSharpe Ratio14464–1.9244.44%1 Month14251–0.8435.92%3 Months42–0.8730.22%6 Months13913340–3.7930.08%12 Months127230.5118.11%18 Months12113–1.8910.74%24 Months
1996
K-ratio–0.63–0.37–0.17–0.850.02–0.58
Net Profit by Year
Net Profit–1,469,361–579,241–1,217,603–1,790,056481,951–1,319,288
1994
Performance Breakdown by Year
AverageAverageAverage Average Avg. Profit AverageAverageWinK-ratio Sharpe Ratio Max DD Num Trades % Win Per Contract–667,62977–0.0435–0.02251,468760.13462620.4070,212–433,561–1,773,84016,11393–0.7119–1.30–1,839–511,56770–0.03360.01353,737–270,60872,960640.21470.5813–693,04977–0.1633–0.35–836,636–611,36473–0.1032–0.33–1137,372
Channel Breakout Strategy Applied to Relative Value Markets. The Channel Breakout Strategy does not generate profits on our relative value markets.
FIGURE
1990
Net Profit2,509,119744,226–1,210,463–537,939396,370–776,681
3,000,0002,500,0002,000,0001,500,0001,000,000500,0000–500,000–1,000,000–1,500,000–2,000,000–2,500,000
Year199019911992199319941995
Breakdown Statistics (Relative Value)
40 day entry/20 day exit channel breakout40 day extreme for entry, 20 day extreme for exitEnter on a 40 day extreme close; exit on a 20 day extreme close1/1/1990-12/31/2001Breakdown by Market Sector
AverageMarketNet ProfitSectorRates14,322Credit1,027,158Volatility–1,628,700Commodity37,837Stock Index1,110,652Stock Pairs–445,739Stock/Comm. –468,456
System Name:Parameters:Description:Run Dates:
Net Profit
PART 2 Harnessing the Power of Quantitative Techniques to Create a Trading Program
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FIGURE
9.19
Moving Average Crossover Applied to Two’s-10’s Yield Difference. Our Moving Average Crossover tendsto get whipsawed, buying at highs and selling at lows.
StochasticsTwo oscillators are tested on our relative value markets. The first uses a 14-daySlow %K stochastic to generate long and short entries. Long entries are established when today’s 14-day Slow %K stochastic falls below and then rises backabove 20. Short entries are established when today’s 14-day Slow %K stochasticrises above and then falls below 80.Our first countertrend trading strategy produces attractive profits whenapplied to our 30 relative value markets (Figures 9.22a and 9.22b). After losingmoney in 1990 and 1991, applying a 14-day Slow %K stochastic to trade has generated profits in 7 of the past 10 years. Especially strong are the results generatedfrom trading volatility and stock pairs.Relative Strength IndexIn testing a 14-day Relative Strength Index, long entries are established if today’s14-day RSI falls below 35 and short entries are established if today’s 14-day RSIrises above 65. There are no other rules and no rules for exiting positions, exceptfor an entry in the opposite direction.The chart in Figure 9.23 details signals applied to the yield spread betweentwo-year and 10-year Treasury notes. As spreads rallied in late March, the 14-day
CHAPTER 9 New Ideas of Markets
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Trading Strategy Evaluation (Relative Value)10 day/40 day Dual Moving Average Crossover10 day average, 40 day averageEnter long when 10 day average crosses above 40 day average, short on cross below1/1/1990-12/31/2001#Avg.Avg. Avg.SharpeAvg.Avg.Avg. Bars BarsofProfit%MarketNet Profit K-ratio RatioMax DD Trades Win hrs (000) Per Con. WinLoss Win Loss38 332.85Yield235,256 0.02 0.11 –584,486 88659,209 –32,410 51 222's-10's–299,835 –0.11 –0.15 –1,029,865 112 42 461.21–634,718 –30,051 36 202's-5'sCurve36 566.74904,718 0.09 0.46 –428,450 921561,407 –20,942 56 1910's-30's–13 32,664 –26,604 43 202-10-30 Fly –616,285 –0.17 –0.37 –932,295 106 33 560.29Credit519.21284 33,485 –28,902 43 18Swap spreads 271,450 0.12 0.11 –292,000 9736 159.1590 100,808 –34,916 66 20High yeld 1,237,047 0.12 0.44 –358,206 80SpreadsVolatility–1,209,060 –0.51 –0.85 –1,421,540 133 319.86–957 15,644 –20,612 36 16VIX44 639.96Commodity958,174 0.07 0.44 –450,085 961658,487 –27,044 48 19C/W39 1056.71482,926 0.14 0.24 –406,788 85560,645 –29,019 58 21S/BO40 1345.46–603,895 –0.12 –0.30 –1,193,963 93–536,928 –35,690 51 19S/SM34 917.04417,735 0.06 0.23 –288,898 76563,237 –25,697 65 26GC/SLStock44 1051.221265,563 –28,419 59 17SPX/NDX 1,099,510 0.09 0.61 –350,194 8241 1713.06882,016 –34,813 64 19SPX/RUT 1,149,401 0.25 0.53 –232,086 80IndicesStock–13 30,786 –22,318 47 20BSC/MER –648,514 –0.17 –0.42 –870,916 104 30 482.2034 500.79–13 39,031 –29,913 54 19CVS/WAG –639,632 –0.08 –0.38 –915,779 98Pairs–836,853 –28,616 41 17DAL/AMR –635,213 –0.07 –0.34 –764,648 116 35 723.7543 588.572,1220.01 0.00 –554,597 98036,763 –27,766 45 20DD/DOW–627,629 –22,193 42 18FNM/FRE –520,110 –0.13 –0.34 –954,381 113 35 802.0541 617.00468,689 0.08 0.27 –310,006 91752,745 –28,927 56 17GM/F–14 36,329 –29,546 44 17KO/PEP –1,054,047 –0.18 –0.56 –1,095,996 118 31 624.47–347,303 –29,500 51 17MOT/TXN –125,835 –0.04 –0.07 –669,719 101 37 391.0043 456.512061,488 –30,945 56 17MSFT/INTC 820,567 0.13 0.42 –376,788 88–637,001 –27,463 46 18PFE/MRK –420,003 –0.12 –0.24 –512,535 106 37 623.27–726,397 –0.31 –0.47 –886,050 113 41 742.97–921,697 –26,148 36 20VZ/SBC41 521.10–217,049 0.01 –0.13 –709,965 86–530,033 –25,378 54 21WMT/HD–335,730 –0.10 –0.19 –674,743 104 30 675.33–546,867 –24,377 50 19XOM/