1. System Name: Index “Channeling” system (ver 1.4; Feb 01, 2013)
  1. System description:
  1. A short-term mechanical system, with a few simple rules that can be operated with end of day prices that has a high win % and well defined entry, exit and position sizing rules.
  2. This system harvests the normal cycling of broad world market index ETFs that are in a bull market, by buying them when they are in a short term oversold condition and selling them as they reach short term overbought conditions.
  3. The system anticipates that the normal cycling of short term buying and selling associated with a bull market will continue. It buys and sells routinely inside the upward trending channel when the reward/risk ratio is in its favor.
  4. This system spends a lot of time in cash, and thereby avoids the losses of the routine retracements away from the short term trend.
  5. Hat tip to research ideas of buying on dips in trending markets from Robert Haugen, Dave Landry, Larry Connors, Michael Covel and Perry Kaufman.

3.  System logic, concepts and definitions:

  1. The normal channel is defined by highest high and lowest low of the last 10 trading days, which we can easily measure by means of the Williams%R (10) indicator.
  2. The short term trend is defined by the 10 day moving average, which will represent the short term trend’s “fair price”.
  3. The primary trend is defined by the relationship of price to the 200 day Moving Average. Price greater than the 200 day MA is a bull market. This system will only go long and only when we are in bull markets. Bear markets are more volatile than bull markets, and are not as often characterized by quiet trending channels.

d.  When the indexes move away from the short term trend and the primary trend, 2 things can happen.

  1. Primary trend continues: Sellers have been capturing normal profits in order to redeploy money to other sectors. Selling pressure has temporarily suspended the upwardly biased bull market move of the index, and thereby created an opportunity for long term buy and holders or true believers in the bull market to “buy on a dip”. This triggers an influx of buying pressure which will reverse the decline and move the index back towards the primary upward trend. In bull markets of this type there is more short term buying interest than selling interest and thus the index continues to climb. When the index gets into short term overbought conditions, there is no longer a “buy on dip” opportunity and the index stalls. If it made a new high on this swing upward, it is easy to believe in the continuation of the bull market, and that the next round of selling is not likely to be panic selling, but simply a repeat of normal short term profit taking which does not jeopardize the belief in the bull market. This is the market condition and the moves we are trying to capture, focusing on the sweet spot, the best part of the curve, capitalizing on the enthusiasm of the urge to “buy on the dip”.
  2. Primary bull trend reverses: On the other hand, it may be the first move towards a trend reversal, a sea change in the primary trend, in which case there will not be an immediate resumption of the previous trend. When this happens, the index may trade sideways for a time, as bulls and bears struggle. So, if the trade has not moved in our favor in a week, we exit, because something else is going on, and we will not remain in the market waiting to see how it sorts out. We want the easy move, the rapid return to normalcy. If the sea change is dramatic, our initial capital preservation stop will protect us from excessive harm.
  3. Long trigger: the daily close registers an extreme oversold condition in the index’s short term price action. This defines a “significant” enough move to constitute a trading opportunity. It is not unusual to see this occur after 2 -3 days of a hard sell off after a nice leg up.
  4. Williams%R(10): is a simple, intuitive technical analysis tool that classifies the current price into one of 3 conditions: Overbought, Normal, or Oversold by comparing price to the Highest High and Lowest Low of the last 10 days, and expresses it in a range of 0 to -100. We select 10 days as our lookback period as it represents 2 weeks of trading, and is in the middle of the time period definition of swing trading, which we consider to be “short term” trading money. It gives a reading of 0 to -100, with the range 0 to -20 classified as OverBought, -20 to -80 as Normal, and -80 to -100 as OverSold.
  1. Targetted ETFs: Large liquid ETFs that match the major indices of the world market:
  2. SPY: the S&P 500 index
  3. QQQQ: the NASDAQ 100 index
  4. DIA: Dow 30 industrials
  5. MDY: the Russell 400 Midcaps
  6. IWM: the Russell 2000 Smallcaps
  7. IGW: the Semiconductors HOLDR
  8. EFA: the MSCI Europe-Asia index
  9. ILF: Latin American 40 largecaps
  10. EEM: Emerging Markets
  11. EPP: Asia less Japan
  1. Historical performance:
  2. in backtesting from 1994-2004 in the US ETFs and in prototyping for 2 years, all years have been positive and have outperformed the S&P 500 buy and hold strategy. It has been in cash greater than 75% of the time, and the win rate has been better than 65% , with average wins greater than or equal to average losses.
  3. In backtesting from 2002 to 2010 in US ETFs and International broad indices (less Japan); 3 negative years, outperformed buy and hold; win rate 74%

6.  Entry rules:

  1. Long Rules;

Rule # / Rule / Comment
1 / Close > 200 day MA / Trade in the direction of the primary trend
2 / Williams%R(10) <-80 / Index has sold off to create short term Oversold conditions
3 / Add a 2d position if Williams%R(10) < -80 while in the trade / The sell off goes on and creates an even more extreme Oversold condition

7.  Exit rules:

  1. Normal exit: Exit tomorrow at the open, when today’s close generates a Williams%R(10) > -30
  2. When an index gets an exit signal, exit both positions.

8.  Position sizing rules:

  1. Maximum 2 positions per index
  2. Maximum 10 positions
  3. Maximum 10% of capital in any single position
  4. Maximum of 20% of capital in any single index
  5. Buy in equal dollar amounts

9.  Optional decisions/rules:

  1. Windfall profit exit: if you a 5% gain in a position, either cash it or tighten your trailing stop to 1% trailing stop.
  2. Time exit: exit at the open of the 8th day if you are still in the trade and no other exit has been triggered.
  3. For broad US indices (DIA, SPY, QQQQ, MDY, IWM): use a 3% initial capital preservation stop loss. Use a trailing stop. Reduces performance, but protects against catastrophic loss
  4. For Semiconductors (IGW) and international indices use a 5% initial capital preservation stop loss. Use a trailing stop. Use a trailing stop. Reduces performance, but protects against catastrophic loss
  5. To reduce volatility, you could elect to take only the US index signals
  6. To reduce volatility you could take ½ of your normal position when rules 1 and 2 fire ,but not rule3.
  7. To reduce volatility and trading frequency you could elect to not trade when rules 1 and 2 fire, but not rule 3.
  8. To operate within a retirement account, you could employ Powershares inverse ETFs to go long on inverse ETFs and actually be taking a short side position.
  9. To reduce volatility, you could elect to not take signals when price is within 2% of the index’s 200 day MA, since there is more whipsawing when the long term trend is not fully established.
  10. To reduce high tech exposure you could elect to not take IGW signals when you get both QQQQ and IGW signals on the same day
  11. To try for more profits, you could elect to trail successful trades with a 1x ATR% trailing stop or 3% trailing stop and try to convert this trade into a longer term trend following position.
  12. To reduce trading frequency, you could elect to treat the first signal in an index as a setup and only take the 2d signal.
  13. To reduce volatility, you could elect to only take the first signal per index
  14. Intraday traders could elect to try to improve intraday entries and exits through the use of pivot points or other intraday indicators
  15. Aggressive traders could elect to use Powershares leveraged indices to get more volatility out of each trade
  16. Futures traders could use these ETF signals as signals to be implemented in the futures markets
  17. If you enter a position on the 1st signal, and then price moves against you and you are stopped out by the initial capital preservation stop, you will often find that that creates a new entry signal (ie for the 2d entry signal). If your initial stop was not in the market, you could elect to maintain the position as if it were your 2d entry, and keep a single position.
  1. Preferred brokers: low cost transaction per share is the most important decision criteria for this system. If you are an intraday trader trying for more, then consider slippage and speed of execution as well. Any large deep discount broker should satisfy these requirements.
  1. How to start the portfolio from all cash: Paper trade this for 3 months or until you are comfortable with the number and type of signals you receive, and that you are comfortable that you can respond to the signals and set the buy/sell orders and trailing stops. Consider trading at a reduced equity size with real money at a deep discount broker in order to build confidence and professionalism with real money before increasing size.
  2. This system can be used as a research indicator for broad market tendencies; It can be traded with judgment and discretion with much tighter stops for better reward:risk characteristics. The mechanical system hits singles; it can be adapted for extra base hits