Trading Strategies: What Worked

The last five years of markets have given traders plenty of challenges and plenty of opportunities. From huge rallies to punishing crashes, and from record volatility to tight trading ranges — the markets have gone through a huge variety of conditions. As the new year starts, it’s worth taking a look back to see which strategies have made money, and which haven't.

Fidelity’s Kent Thacker, director of brokerage products, tested the 30 trading strategies that come preprogrammed in Wealth-Lab Pro^® through the last five years to see which ones would have made you the most money, and which would have cost you. Of course, just because these strategies worked in the past doesn’t guarantee they will work in the future — conditions may change — but using Wealth-Lab’s backtesting capabilities can help make you a more informed trader. Seeing what has worked in the past can help you make an educated decision in the future.

The top three
To find out which of these trading strategies generated the most profits over the last five years through November 30, 2009, Thacker backtested all of the stocks in the S&P 500^® Index using the 30 trading strategies built into Wealth-Lab Pro. For this test, he assumed an investment of $10,000 per trade.

The hypothetical results of the backtest are displayed below: 

 

According to this test, the top three strategies for the time period were the LDL2 (0.96, 2, 3), the Moving Average Crossover strategy (20, 50), and the RSI Agita (20, 30, 55). This doesn’t mean you should run out and immediately use these strategies. But you could use the results “as a starting point to investigate further,” Thacker suggests. Here’s a closer look at these three strategies.

1. LDL2
The strategy: The LDL2 strategy is a technical trading strategy that tries to find stocks on a dip, and get in at the bottom. The system aims to enter the market at oversold levels and exit after the reaction has leveled off.

Analysis: The strategy was extremely sensitive to the volatility of the market. The large downward movements of 2008 and volatility of 2009 created buying dips that this strategy capitalized on, leading to a large net profit.

While this strategy was ultimately very profitable, investors may want to take a closer look. The buy-on-the-dip LDL2 has some limitations. Over the five years, an investor following this strategy would have made 33,000 trades. The large number of trades would not only be incredibly time consuming, but would also generate a lot of commissions.

Additionally, while this strategy did very well in 2008, the buy-on-the-dip strategy did not perform as well during the up markets from 2004-2007. Sustained upward trends provide fewer buying signals for “dip” strategies. An additional consideration for dip-buyers is that a prolonged downtrend could cause significant losses.

“With every strategy there will be advantages and disadvantages,” Thacker says. “Part of the challenge is knowing what you are trying to accomplish by using this strategy.” Put another way, you need a plan and goals.

2. The Moving Average Crossover Strategy

The strategy: The Moving Average Crossover strategy is popular with many traders. It’s actually quite a simple strategy: Buy when a stock’s 20-day moving average (MA) crosses over the 50-day MA, and sell when the 20-day MA crosses below the 50-day MA.

Analysis: The idea behind this strategy is to buy at the beginning of the trend and ride it until it ends. “When you do hit a trend,” Thacker says, “you will be following its sweet spot.”

Toni Turner, best-selling author of A Beginner’s Guide to Short-Term Trading (Adams Media, 2008), was not surprised when we told her that the Moving Average Crossover strategy was ranked as a top-performing strategy in the backtest. “The Moving Average Crossover has worked the best for me. It is elegant in its simplicity.”

Turner adds that sometimes traders feel they need complicated charts loaded with indicators. “The simple truth is that if we establish a rule-based system and use moving average crossovers, we can make a very good living in the market,” she says. The default variables in Wealth-Lab Pro are the 20-day and 50-day moving averages. Turner uses those settings in her trading system, but also employs the 8-day and 13-day moving averages on a daily chart.

Looking at the results, the Moving Average Crossover strategy generated almost the same net profit as the LDL2, but with half as many trades.

Thacker noticed one variable that should be considered. “You can see that the percentage of winning trades (42%) is rather low. It means there are a lot of false breakouts, which can be discouraging to some people because you’ll have a series of small losses.”

3. Relative Strength Index (RSI) Agita

The strategy: The Relative Strength Index is a momentum oscillator — that means it looks at how quickly a stock is gaining or losing price and tries to detect changes in the pace of the price change. The indicator assumes that as the price gain or loss slows, you may be approaching a turnaround.

Analysis: The RSI strategy is built to take advantage of oversold conditions. The strategy paid off over the last five years, and particularly among the last two years — when this was the best-performing strategy of the 30 Thacker tested.

One reason it works so well is that the strategy continues buying stock as conditions grow more oversold, so that it builds up a larger position when prices are down, according to Thacker.

For this test, the RSI strategy’s win ratio was 67%, significantly more than the Moving Average Crossover strategy, which succeeded just 42% of the time.

Of course, the RSI strategy has risks as well. Followers of this strategy buy into positions as stocks become oversold, anticipating a rebound. If the downtrend continues, traders following these types of strategies can expect occasional significant losses. Traders can limit the impact of such occurrences by trading the strategy across multiple stocks, and by limiting the amount of trading capital devoted to such strategies.

A losing strategy
In addition to finding out the top three strategies, Thacker also studied the less successful strategies for this time period. Using the default settings, the Bandwagon Trade was highly unprofitable.

Bandwagon Trade

The strategy: The Bandwagon Trade uses the Average True Range (ATR) as its main indicator. The ATR attempts to measure a security’s volatility over a certain period. After you enter the position, long or short, you immediately set an exit strategy using calculations built into the strategy. 

Analysis:  The bandwagon strategy struggled during the five-year period, failing to deliver significant profits in either the down market of 2008 or the rally of 2009. Chris Clark, director at Fidelity, thinks the poor performance might be due to the reactive nature of the trading strategy. “With this strategy, you are buying into positions after a strong initial move up or down,” says Clark. “With the high volatility we’ve seen, there haven’t been a lot of sustained uptrends or downtrends and you may be missing the price move.”

If you use a strategy that ends up at the bottom, like the Bandwagon Trade, you might want to examine why. Review your previous trades to determine if using this strategy makes sense in the future. Sometimes, a strategy that fails during one market cycle might shine in another.

Why backtest?
The main reason to backtest is to “see if your strategy works before putting real money into it,” says Thacker. In addition, the next time someone tells you about a new trading strategy, you can verify the results. Several years ago, according to news reports, an investment bank backtested Bernard Madoff’s Ponzi-scheme trading strategy, and couldn’t match his data. This blaring red flag convinced them to invest elsewhere.

“Wealth-Lab Pro allows you to create your own strategy or tweak existing ones,” says Thacker. “At first, many people start with a pre-shipped strategy.” The program also allows you to play “what if” games, trying to create a better system.

He says you can also use Wealth-Lab Pro to go back in history to test how well a strategy would have performed during similar market conditions.

Rank strategies
To rank your strategies or compare them to benchmarks such as the S&P 500 Index,^® Dow Jones Industrial Average, or Nasdaq 100, you will need to download Wealth-Lab Pro. There’s a 30-day trial period for Fidelity customers. After it’s downloaded, double-click on the Wealth-Lab Pro icon and an uncomplicated home page appears.

From the Tools menu, select Strategy Ranking, click + Add Strategies, then choose one or more strategies. Select Basic or Extended Scorecard, which displays the default measurements that come with the program. Finally, select Begin. The strategies are ranked and the information is displayed. To change the rankings, for example, click on Net Profit and the strategies will line up from most profitable to least profitable.

You can download additional strategies or modify the existing strategies with your own specifications.

Ranking strategies gives you some relative performance numbers, but by backtesting each individual strategy, you can gather even more data. You can easily tweak the value of the indicators and optimize the strategy for your own uses.

 To learn more, visit Fidelity.com.

(Tell us what you think about this article. E-mail comments to Fidelity.Investments@fidelity.com.)

Michael Sincere is a freelance writer and the author of five books on investing and trading, including Understanding Stocks (McGraw-Hill, 2003) and Understanding Options (McGraw-Hill, 2006).

Backtesting provides a hypothetical calculation of how a security or portfolio of securities, subject to a trading strategy, would have performed over a historical time period. You should not assume that backtesting of a trading strategy will provide any indication of how your portfolio of securities, or a new portfolio of securities, might perform over time. You should choose your own trading strategies based on your particular objectives and risk tolerances. Be sure to review your decisions periodically to make sure they are still consistent with your goals. Past performance is no guarantee of future results.

Wealth-Lab Pro is available to investors in households that place 120 or more stock, bond, or options trades in a rolling twelve-month period and maintain $25K in assets across their eligible Fidelity brokerage accounts.

The opinions of the experts presented herein are their own and are not the opinions or recommendations of Fidelity Investments. These materials are provided for informational purposes only and should not be used or construed as a recommendation of any security. Fidelity Investments does not guarantee that the information supplied is accurate, complete, or timely, and does not make any warranties with regard to the results obtained from its use.

The NASDAQ-100 Index (ex-dividends) includes 100 of the largest non-financial companies listed on The NASDAQ Stock Market based on market capitalization. The Index is a market-capitalization weighted index that is designed to represent the performance of the National Market System, which includes stocks traded only over the counter and not on an exchange. This index does not account for reinvestment of dividends.

The S&P 500^® Index is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates. It is an unmanaged index of the common stock prices of 500 widely held U.S. stocks that includes the reinvestment of dividends.

The Dow Jones Industrial Average (DJIA) is an unmanaged price-weighted index and is the most widely used indicator of how the country’s industrial leaders are performing. Also known as “the Dow,” this is a formula based on the stock prices of 30 major companies chosen from sectors of the economy most representative of our country’s economic condition.