Market Lab Report - How Experience Can Work Against You

Published : March 10 2016 at 21:59 ET

Experience can work against a trader especially in this age of quantitative easing where statistics and tendencies that used to be true are now false. One of the biggest challenges has been to take every signal the VIX model issues. Due to my, call it over-experience, I have not taken two signals this year that were issued by the model, both which were highly profitable (+24.67% and +7.39% using 2x ETF UVXY). I also delayed taking this morning's fail-safe which would have resulted in a loss of -3.2% (using 2x ETF UVXY) instead of a -6.89% loss (using 2x ETF UVXY). I did so with good intention because experience showed blah blah blah... If we substitute the word "experience" with the word "ego", only then does the learning begin.

The backtests are what they are and have shown the model to work well across a variety of markets. So it is key for me at this point to let the model and its self-learning fail-safes do its thing without overriding any of its signals or fail-safes. That means having a strong stomach to withstand the very rare time when it might get whipsawed three times in a day. The very rare times this has occurred in backtests, the losses from all three losing trades never amounted to more than 6% (using 2x ETF UVXY). Any losing trade typically has a loss of breakeven to -3%. 

That said, the model has scored a few 15%+ intrasignal gains as we have indicated in the reports since its launch in late December 2015. Those who took such quick, steep profits are still up nicely this year. That said, the backtests and results shown in the VIX performance table excludes taking such early intrasignal profits. Still, even without early profit taking, the model was up in every rolling 12-month period over the entire testing period.

With that in mind, a complete rundown of all trades, both backtested and real-time, showed that taking certain profits early has further increased reward overall without increasing risk. Thus, the model will now include early profit taking on certain buy signals as we know some members are unable to watch their positions but instead monitor emails from VoSI to guide their trades. We will only do this for buy signals (buying volatility) since the market tends to take the stairs up and the trapdoor down, thus the +15% profits achieved in a day or two as demonstrated in real-time by the model.

As we have mentioned, it is important to know that the model can have a string of small losses. Indeed, the model is going through a drawdown at present if we exclude the intrasignal 15%+ profits. Losing periods can last a few months. The key is to take every signal since losses tend to be small while gains can be quite large, especially on buy signals where the model buys volatility. Unfortunately, it is improbable to know the magnitude of potential profit of any given signal. Nevertheless, the model has well outperformed the major averages every year in the backtests.

Keep in mind that the only thing that does not change is change, so past results can never guarantee that future results will be equivalent. Indeed, it was easy to become overconfident when the model would go on hot streaks at certain times in prior years only to be sometimes followed by a drawdown period. It did this most recently in 2015 from February to August when its sizable profits were followed by a lengthy drawdown. The sizable profits over this period were especially surprising given the trendless nature of 2015, a year which by some media accounts was the toughest year in 78 years. With regards to the model, overconfidence ruled the day. But then the model had a drawdown so oversizing would have been a bad strategy.

Keeping greed, fear, and over-experience in check is always a valuable lesson as greed can lead to oversizing a position while fear and over-experience can lead to not taking a trade. The model's two signals that I overrode can make a big difference, especially in these markets that seem to grow increasingly challenging with each passing year such that finishing the year up 15-25% is astounding, let alone making that return in one trade.

The reassuring news is that the model is working as it should, with or without the early taking of profits. But the early taking of profits in place serves to further increase reward without increasing risk.

This information is provided by Virtue of Selfish Investing, LLC (VoSI) is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. VoSI reports are intended to alert VoSI members to technical developments in certain securities that may or may not be actionable, only, and are not intended as recommendations. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to VoSI, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Virtue of Selfish Investing, LLC. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2016 Virtue of Selfish Investing, LLC. All rights reserved.