Once again Brett Steenbarger has provided invaluable advice to traders. (We make note of his themes where we want to pursue the discussion, but we are hopelessly behind the prolific Dr. Steenbarger. We will never catch up! Most traders know that they should read his site every day, as we do.)
Let us recap his analysis and then try to add to the discussion.
Dr. Brett recounts the case of a real trader (fictional name of Chris) who had a long-only system.
Chris has developed a trading method that is long only. He looks at the Bollinger Bands (volatility envelopes) surrounding the 20-day moving average for the S&P 500 Index (SPY). If we close above the upper band/envelope, he buys the market on close. If we return to the area between the bands, he exits the position to limit losses. His idea is to participate in strong trending markets.
As we read this, we were quite skeptical. Discussing it in our office, we noted that it was close to the opposite of what our models suggested. We try to participate in trends by watching long-term moving averages and short-term crossovers. While this is a gross over-simplification of our system, developed by our astute modeler Vince Castelli (results currently report weekly on the TickerSense Blogger Sentiment Poll), it captures the general idea. Meanwhile, Vince's models find mean-reversion in over-extended stocks for short-term trades of the type Chris did.
So how did Chris do?
Brett reports the following:
He had an effective system--if he had traded it in reverse. Traders need to understand how markets move on *their* time frame. Much losing of money among short-term traders can be traced to the mistake made by Chris. What occurs on the longer time frame and at shorter time frames can be quite, quite different.
Brett's analysis pursues a theme that he and we have discussed before -- good games and time frames. If you do it wrong, this is what happens:
Overall, Chris lost about 90 S&P points trading long positions in a bull market with perfect market discipline and psychology.
WOW! This is an exceptionally well-put and dramatic assessment of how a trading system can go wrong -- without proper testing and time frames.
Meanwhile, there is an important lesson for investors. For the average person, being in the right asset class at the right time is the most important investment decision. You do not need to catch the top or the bottom, but missing big moves is costly. If you are a long-term investor, your entry and exit should reflect the time frame. Do not miss the big moves by attempting short-term market timing.
If you are a trader, the indicators may be quite different, and system testing is absolutely necessary.
Our guess is that many traders fall into the "Chris trap", so vividly described by Brett. We also suspect that many long-term investors prematurely sell stocks and reduce positions because they focus too much on short-term timing.