Check out this case study

First of all:
When you have a strategy, you want to know, when to enter a trade and when to exit a trade. All examples in the last mail didn’t have any exit. But the exit is crucial to examine the profit of a strategy. If you don’t know, when to exit a trade or investment, you don’t know how much money you made or lost.

The strategy I want to show you has a simple framework:
If the RSI crosses under 30, then buy 100 shares of SPY.
If the RSI crosses over 70, then sell 100 shares of SPY.

I give you here a brief definition of the RSI, but you don’t have to understand it in detail, because the RSI is an indicator, which you will find on nearly every charting tool.

The RSI ( Relative Strength Index ) is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset. It is calculated using the following formula:
RSI = 100 – 100 / (1 + RS)

Where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame.

Normally the length of the RSI is 14 bars. In our strategy we shorten the length to 2 bars.

Provided with this information we can use this strategy and apply it to any stock or market. We will test the strategy with the SPY. It is an Exchange Traded Fund, which tries to mirror the biggest and most liquid stock market in the world, the S&P 500.

Let’s take a look at the performance of this strategy for the last 20 years:

As you can see, the strategy would have given us some nice profit over the last 20 years.
We made approximately 460 trade and achieved 22,000 USD Profit.
This is on average 47 USD per Trade (22,000 / 460 = 47).

Every green dot marks a new equity high in your profit curve. You can see, that most of the time your profit will increase.

Critical are the times, when you don’t see any green dots, for example between Trade number 50 and 110. This is the drawdown of the strategy. In this environment the strategy does not perform very well and you will suffer a loss.

At this time arise 2 questions:

  1. Do I sustain this drawdown?
  2. Is the strategy broken?

The first question is the same question, I asked you in our first letter and in the second letter again. May be that it is boring to you, but if you suffer the real loss – “hey, the money is gone!” then you will know whether you can sustain the drawdown or not.

When the drawdown arises you will never know, whether the strategy is broken or not. Unfortunately you will know it only in hindsight. Therefore we use as a proxy the historical drawdown of a strategy. That’s why it is necessary to have large historical data from the strategy.

Okay, let’s summarize what we have learned in this lesson

  1. A strategy contains clear entry and exit points
  2. A strategy provides historical data, the more the better
  3. A strategy provides an average gain per year or trade
  4. A strategy provides a maximum drawdown

 

If you have a performance report there is no more guessing and gambling. With a clear strategy you know when to enter and to exit a trade and what you can expect from this strategy.

So, as always at the end of every lesson, you get your homework.

  1. Write down what you like about this solution
  2. Write down how much money you would invest in this strategy and why

 

Best wishes
Bernd

In the next lesson you will learn how proper position size will affect a strategy. Talk to you soon.