How Did We Do In A Declining Market?
Case Study January 2019
As we have just entered the new year, and the market has just suffered a 20% down move, it's a good time to look at the results of a simple strategy based on our data and tools, over this backdrop of a significant market correction.
An excellent strategy for trading the data we provide here is to trade a spread. Also known as Long-Short Equity trading, I cover this in detail elsewhere on the site. In brief, it is pretty much what it says on the tin -- you buy one stock and simultaneously short another. And, of course, ranking sectors by relative strength gives us exactly the information to do just that -- we get to see which sector is performing best and which is performing worst. We buy the top sector, and sell short the bottom sector. There are other elements in the decision making and in the trade management, of course, but that's the concept, at it's simplest.
By the 9th November 2018, the Utilities Sector had been at the top of the Relative Strength rankings for several weeks. That week, the Energies Sector hit the bottom ranking. That gave us a reason to look at trading long the Utilities sector ETF, XLU and short the Energy sector ETF, XLE.
In order to place such a spread trade, we should look at a chart of the spread, and apply some simple chart analysis to time an entry.
As it turns our, the XLU/XLE spread gave us a very good entry signal on Nov 9, on top of the Relative Strength ranking rationale.
My screenshot here shows the XLU/XLE spread charted in Amibroker.
If you're not an Amibroker user, spreads can be charted quickly and easily on a free chart at StockCharts.
The 9th Nov is the second blue arrow. There are a number of reasons why this is a good signal.
At the first blue arrow on 12 October, the spread broke above its 50-period moving average––the orange line. This is a bullish signal, but the spread was not yet on our radar at that time and also, the spread is still in a consolidation area, with the red horizontal line overhead highlighting two tops in a range.
The spread continued up and broke above the range––another good bullish indication. By the time we get to 9th Nov, where we are actually first looking at this, we are in an ideal spot––the spread has made a strong move above its 50-period MA, it has broken out of consolidation, and it it is just now making its first pullback after breaking above its 50-period moving average. And the spread has turned back up.
So, firstly, we have a sound reason to be looking at a spread for these two ETFs––the high and low Relative Strength rankings––and we also have a good setup on the spread itself, for entry on 9 November.
Here's what happened, based on closing prices on 9 November, up to the close on 2nd January 2019:
Here's what a chart of the S&P 500, represented by SPY, looked like at the right edge on 9 November:
The market had just had a 10% drop and had made a bounce. Would we be bullish on this day, expecting the rise to continue? Or would we be bearish and expect a further fall? It turns out we don't need to worry about that--we don't need to attempt to predict (just as well, really, because the bottom line us nobody can predict it...)
In fact, after putting on this spread trade at 9th November, the market fell 16%, as I'm sure we are all aware by now.
But we didn't have to worry. The beauty of trading a spread is that you don't need to be right on the market direction. You can hedge out market risk. You are both long and short at the same time, so one of your trades stands to benefit from a market fall, and the other stands to benefit from a market drop. All we need is for our long trade to go up more than our short trade, or our short trade to go down more than our long trade. Either will do, we make a profit either way.
And the Relative Strength rankings give us a high probability that this is exactly what will happen, regardless of market behavior.
This doesn't mean that every spread trade will work--that will never be the case with any strategy. But we do have a very high probability in our favor, and that is the most we can expect from any strategy--and it's all we need.
So, in this case, in a market that fell 16%, our long XLU trade was down 4.59%--here you see Relative Strength at work--XLU continued to be much stronger than the rest of the market, so it fell less than the market fell.
Meanwhile, our short trade on XLE took full advantage of the market drop, making us 17.49%
So the net result of the spread trade was 12.9% profit in a period where the market fell 16%, without giving us sleepless nights worrying about the falling market.
Exactly the same thing is typical of a spread trade in a rising market--the high Relative Strength stock will most likely out-perform the market, while the low Relative Strength stock can be expected to at least go up less, and maybe even go down--both of which come out in our favor.
This is exactly why Long-Short Equity trading is one of the most favored and widespread strategies in hedge funds. It may well be the strategy which is most used.
And the strategy is an excellent match for the data and tools we have put together here.
We could also have used our database to dig deeper into the Utilities and Energy Sectors, and find the strongest stocks in Utilities and weaker stocks in Energies. But trading the Sector ETFs is a simple, quick and easy way to put this data to work in a straightforward manner.
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