The SK Momentum System: Our Key to Trading Equities

Monday, December 1, 2014 at 03:03AM

SK Options Trading

SK Options Trading

There are many factors that affect the overall movement of the stock market. However, today we will consider just one of these, one that we believe carries considerable weight and is key for predicting the how stocks perform: momentum. Through our analysis of momentum we have produced a model based momentum trading system (SK Momentum System or SKMS), which boasts a Sharpe ratio of 3.49 since 2002 and a return of 57547% since 1950.

The reasons that momentum is such an important factor when considering the future movement of equities markets can be broken down to the old adage, “the trend is your friend”. If stocks are trending higher investors are more likely to buy than sell, as they believe that the rally is likely to continue. The result of this is rising stock prices will drive prices even further higher, at least for a while, as new investors bet on the trend continuing. There is a similar phenomenon when equities are falling, as a small selloff can cause a larger panic that forces prices much lower and at a faster pace. Thus, momentum in stocks can drive rallies higher and selloffs lower than their underlying causes. We consider equities to be more momentum driver then many other markets such as bond and currencies, due to their status as a key confidence barometer.

From an academic point of view this is all well and good, but if we want to trade on this we need more information. If one waits until there has been a clear shift they may miss out on potential profits, and if they move too soon they may even lose money by buying into a falling market. At SK Options Trading we have developed our proprietary SK Momentum System (SKMS) that provides produces astounding results.

The SKMS produces very simple, but very useful, information. When an increase in upwards momentum is first detected the SKMS produces a buy signal, at which point one immediately becomes long the S&P 500. Then, as soon as that momentum begins to wane the SKMS will signal to close that long position.

It must be said that the SKMS is not perfect, so we will begin by addressing the main limitation of the system. This is that by exiting a trade as soon as momentum decreases, and not waiting until it has fallen to zero, one misses out on the tail end of most rallies and its potential profits. This means that when we back tested to 1950, in many of the years a portfolio that was using the SKMS would return less than one that was simply long the S&P 500. However, the same process that causes this limitation is also what makes the SKMS so valuable.

By closing trades as soon as momentum has begun to fade one loses out on many small extra profits, but they also avoid massive, portfolio demoralising losses. In fact, an SKMS based portfolio starting in 1950 would have never had a losing year. For each of the 65 years since then, that portfolio would have finished higher, generating an average gain of 10.44% a year to comfortably beat the S&P’s 9.06%. Even trading through the early 70’s when the S&P lost nearly half, the early 2000’s, and the devastating global financial crisis, a portfolio using the SKMS would have still made a profit.

By gauging when momentum begins to wane and closing trades as soon that happens, the SKMS would have turned a mere $100 in 1950 into a massive $57,547.92 today, which is more than four and a half times better than the performance of the S&P 500.

While these returns alone are impressive, one should never target returns alone. To generate these profits risks must be taken and if incorrectly assessed those risks can result in far greater losses that ever expected. This is why we hold prudent risk management as our number one rule of trading. The lack of a losing year in 65 may be sufficient for some investors to show that the returns are worth the risks being taken, but we believe that one must go further than this. To show that each of these winning years is not simply the result of very good luck we will consider the drawdown of an SKMS based portfolio, its volatility, and its Sharpe ratio.

The accuracy of the SKMS in detecting changes in momentum has so far been shown to give signals that are effective enough to outperform the S&P 500 and to avoid major market crashes. In fact, it is capable of proving much more than this. The SKMS gauges the direction and magnitude of momentum to the degree that the biggest loss ever seen on an open trade in 65 years is 1.92% (this is on a close to close basis, not on intraday volatility). In contrast, the drawdown of S&P 500 was more than 25 times this during the GFC.

When a maximum drawdown of 1.92% is considered, it is easy to see that the SKMS produces a portfolio with low volatility. For our volatility gauge we have used the standard deviation to give a measure of the variation in the one year return from the average. We will use this again to determine the Sharpe ratio going back to the beginning of 2002. What this calculation shows us is that the average volatility of an SKMS based portfolio is less than a third of the S&P 500. Even at its peak level the standard deviation is still below 7% for the SKMS portfolio, whereas it climbs above 30% for the S&P 500.

The chart below reflects the low volatility of the SKMS based portfolio by showing the rolling yearly return as relatively stable and consistent between 2.5% and 30%. This is in stark contrast to the S&P 500 that shows higher returns, reaching to almost 70%, but much harsher losses with a nearly 50% drawdown during the GFC. The consistency of returns in the SKMS portfolio means that since 2002 it would be up 425.38%, which is more than twice that of the S&P 500.

Using this information we can quantify the risk reward dynamics by calculating the Sharpe ratio. For those of you unfamiliar, the Sharpe ratio compares a portfolio’s rate of return above the risk free rate to its volatility. In reality there is no truly risk free rate of return, so we have taken the 91 day Treasury bill rate as our lowest risk alternative. Generally, a value of greater than 1 is considered positive and higher than 3 exceptional. In layman’s terms, the Sharpe ratio measures how much extra one makes by taking extra risk.

The first points to be noticed here are incredibly high Sharpe ratios of more than 10 during the GFC and Eurozone crises for the SKMS portfolio. These show that even in periods of panic the SKMS maintains consistent positive returns and low volatility. However, we need to consider risk reward dynamics of the larger timescale as well.

Over more than 12 years the Sharpe ratio for the SKMS fell below zero only in periods when Treasury Bills offered an exceptionally higher return, which happened only 3.05% of the time. On the other hand the S&P 500 showed a negative Sharpe ratio for more than 28% of the time since 2002. This means that for more than 3 years in the last 12 the return on the S&P was less than that of simply holding Treasury Bills.

The SKMS based portfolio had a Sharpe of higher than 1, or better than positive risk reward dynamics, for 84.8% of the time since 2002. The S&P 500 proved poor on this front as well by showing a Sharpe of less than 1 for more than half of the same period, resulting in an average Sharpe ratio of just 0.65. This figure is weak in comparison to the massive Sharpe ratio of 3.49 that the SKMS portfolio produced on average.

From this analysis we are confident in saying that the SK Momentum System’s signals would have provided a far better trading strategy than an outright long position, in terms of both outright returns and risk reward dynamics. Further to this, based on the performance since 2002 we are also confident enough to say that the SKMS remains an incredibly useful tool and a highly accurate indicator of the momentum in equities.

The SKMS gauges momentum so successfully that drawdowns are reduced to less than 2%, ensuring that one would have avoided losing money on market crashes for the last 65 years and gaining 57,547.92% in the process. Even in recent times and the changes that the GFC brought about to the financial markets, the SKMS still produces profitable information. The average yearly Sharpe ratio of 3.49 blows that of the S&P 500 out of the water, as does the 425.38% return. The SKMS is so reliable and effective that we have used it regularly in our analysis to produce multiple profitable trades on the equities markets. Our subscribers have already benefited from this success and if you too want to benefit from the signals of the SKMS, all you have to do is sign up below.

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Article originally appeared on SK Options Trading (http://www.skoptionstrading.com/).

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