Trading With “The Courage of Your Convictions”

• June 12, 2013
• Rob Davenport

“The market does not beat them. They beat themselves, because though they have brains they cannot sit tight… He had not only the courage of his convictions but also the intelligence and patience to sit tight.”

— Reminiscences of a Stock Operator

But what if this time is different? The trader’s fear. You believe in your system, but what if this is the start of a “Black Swan” event?

Too many times traders succumb to the fear and quit trading at exactly the wrong time.

It has happened to many good traders back in 2011. The revolution in Egypt. Civil War in Libya. The earthquake in Japan and a terrible tsunami. Then the nuclear disaster.

In each case the market crashed. Most likely your account was down and you were getting long signals on your trading system (most Machine strategies were giving long signals).

The SPY was down -6% over the period of the Japan disaster starting in March 2011. Over the next 10 days the SPY gained greater than 5%. Many of the strategies in The Machine did much better than that.

Did you take the trades? Or did you quit trading and miss the subsequent upside bounce?

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“Fear keeps you from making as much money as you ought to.”

It is always hard to “see the trade, take the trade” during these periods. The Machine shows you the historical simulated performance of your portfolio for every calendar month and year since 2001, including the new S&P 500 Low-Volatility Growth Portfolio. This certainly helps give you the confidence to “see the trade, take the trade.”

The Returns Distribution Histogram allows users of The Machine to see exactly what the simulated historical returns look like for their portfolios over various periods of time. Below you can see a histogram for a sample portfolio.

 

This histogram shows the returns for every 10 day period for this portfolio going back to 2001. The shaded areas represent the approximate +/-1 sigma, 2 sigma, and 3 sigma distributions. The header of the chart tells us that the average 10 day return is +1.03%. More importantly, the chart shows that approximately 95% (2 sigma) of the returns are above -2% and 99% (3 sigma) of the 10-day returns are above -3.5%.

This information tells the trader that if you are experiencing a period where your portfolio has lost -1% or even -2% over 10 days, that the period you are experiencing is well within the historical norm. This gives traders the confidence to trade through tough periods like we saw back in February and March of 2011.

And, if a true Black Swan event does occur you will have a signal to take actions for your portfolio to protect your capital. For instance, if someone trading this portfolio experienced a -8% return over a10-day period, they might want to go partially or completely to cash as a defensive move. A return of -8% would be completely outside all historical data for this portfolio.

Traders can also look at other time periods. The Machine gives you the ability to look at histograms for returns over periods of 1 day through 10 days, 15 days, 1 month, 2 month, 3 month, 6 month, and one year. These are rolling periods of trading days. Since a year represents 252 trading days, the histogram looks at every 252 day period since 2001 when calculating the returns distribution for 1-year.