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Many trading strategies have been developed over the years, and almost any trading strategy was profitable from 1982 to 2000. The S&P 500 delivered an average annual gain of nearly 15% over those 18 years, without considering dividends. Moving averages and almost any technical indicator work when prices are moving straight up.
Since then, the S&P 500 has delivered a loss of about 1% a year or a gain of almost 1% when dividends are included. In other words, we have seen a different kind of market, and one that requires different trading strategies.
One of the changes in the market has been related to volatility. The chart below shows the history of the CBOE Volatility Index (CBOE: VIX). When viewed as candlesticks, we can see that volatility was normally rather low with small candles being formed most of the time. There were short periods of high volatility, but most of the time from 1990 (when the data starts) until 2007, volatility was low.
On the chart below, we can visually see this change in the size of the candlesticks. On the right side of the chart, most candles are large compared with the left side, indicating that the market is different now than it was years ago.
This new market structure offers a way to create a trading system. Testing will be done from 2007 since that is when the visible shift in market behavior occurred.
The height of each candlestick is measured by the range (the difference between the high and low). This will be the indicator we want to test, and I will use the average true range (ATR), which accounts for the impact of gaps.
A 12-week ATR will show the price range over the past quarter. Dividing the ATR by the close and multiplying that ratio by 100 converts the ATR to a percentage and allows us to compare the current value with historic values. Without converting it to a percentage, the ATR would have a tendency to move higher along with the price and show a persistent uptrend.
To compare the current value of the ATR to where it has been normally, we can add a 26-week moving average to the indicator. If the ATR is above the moving average, volatility is greater than normal, and we expect prices to fall when volatility is high. If ATR is below the moving average, volatility is lower than normal, and we expect prices to rise.
The indicator is shown below with the moving average, and the prices of the SPDR S&P 500 ETF (NYSE: SPY) are in the top part of the chart. Winning trades are shown as green boxes, and the current trade signal is the red box that is showing a small loss right now.
Short positions are taken when the ATR is above the moving average and long trades are entered when the ATR falls below the moving average. This system is always in the market either long or short.
Since 2007, these rules have given 12 signals, an average of 2 trades a year. Six long trades have been opened and closed with five winners. The average long trade provides a gain of 11%. There have also been five short trades opened and closed. Four of them have been winners and the average gain is about 12%. The current signal is the sixth short trade entry from this indicator.
This is a simple trading strategy based on how the market behaves today. It has delivered an annual average gain of 15.91% (without dividends) at a time when the S&P 500 has provided an average annual gain of 0.16% after dividends. As you can see, simple ideas can work very well in trading.
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If present trends continue, or get even worse, it could mean a nasty loss for you and the other players.
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