Some people say that the only thing that works in trading is buying low and selling higher,
and some say that such approach is like trying to catch a falling knife, and that trend following
is much better option. Where’s the truth though? To find out, I will take both trading
approaches, so the one that aims to buy low and sell high and the one that buys high and
tries to sell even higher, optimise both of them to pick the best candidates and compare
their results to see which one is a better option
If you’re new to my channel, my name is David from Critical Trading and I publish
high quality technical trading videos where I backtest and quantify various trading strategies
and tools to provide you with inspiration for your own trading – if that’s something
you’re looking for then subscribe to my channel to get notified when I publish a new
video like this one Let’s start with the first approach – buying
high and selling higher. This approach is a simple trading logic of buying when the
stock has already made a considerable move, where we speculate that the move will be sustained
and the stock’s trend will continue, where obviously we speculate that we then sell the
stock at a higher price. This approach is very common and is a building block of many
trend following and momentum type trading strategies out there. I myself trade systematic
strategies that are based on this logic. For the purposes of this video, I’m going to
test a simple breakout strategy that trades all Russell 1000 stocks and opens a trade
when the stock breaks above a highest price high over a certain time period – such as
100 days for instance. What I’m going to do is I’m going to run a simple optimisation
of the period of the highest high, where I want to find out which highest high length
performed the best in the past. Now, there are some specifics that relate to optimising
the parameters of trading strategies like this that make the process a little more complex
that what I will do here, however this is not a video about optimisation so I’m not
going touch on that here. I’ve got the results of my optimisation
of the highest high length shown on the screen – I run the optimisation in the software
that I use, Amibroker, and I’ve run the optimisation to start with 20-day high up
to the 500-day high breakout, increasing the length by 20 days. For each of the tested
length, I got results that I’m showing here on the screen.
For each of the variants tested, I’ve got all performance metrics, such as the average
annual return that’s shown in this column that I just highlighted. Then, I’ve got
the maximum drawdown of that variant and so on. For the purposes of this video, I’m
going to pick the ratio between the average annual return and the maximum drawdown for
each of the tested variants, which is what I’ve just plotted in a form of a line chart.
Now - what this chart shows is the ratio between the annual return and the drawdown for each
of the variants of the system. Each variant differs in the highest high length that’s
used for the breakout – when the stock closes above the highest high, system buys the stock.
Individual highest high lengths are shows on the horizontal axis – so starting from
the breakout of 20-day high up to the breakout of the 500-day high. The return to drawdown
ratio is shown on the vertical axis, where obviously the higher the ratio is, the better.
The best performing variant of this simple breakout system that buys high and sells higher
is the one that uses a breakout of the 440-day high to buy the stocks. For the purposes of
this video, let’s take this particular version of the system further. However, as I said,
optimising systems needs to be done a little differently to this – it needs to be done
on what’s called and in-sample and out of sample data to minimise the risk of overfitting
the strategy. Now, let’s have a look at a sample trade
of this system. The 440-day high that we picked based on the optimisation is plotted on the
chart in turquoise colour, where we can see that on this particular day I’ve just highlighted,
the high was broken and so a valid buy signal gets generated.
For the purposes of this video, I will test this system with a simple 10 per cent trailing
stop-loss, which is plotted in a form of an orange line. The stop level gets hit here,
on the day I’ve just highlighted, and the position is closed. Overall, a super simple
breakout system that does the opposite of buying low and selling high – it buys high
and aims to sell higher by exploiting the momentum phenomenon that’s been present
in the markets for decades. Now - let’s do the same optimisation exercise
for the breakout of the lowest low instead in order to quantify the opposite logic – buy
low and sell high. To test this, I’m changing one rule only, and that is the breakout level
– instead of buying when the market breaks above the highest high, I’m now saying I
want to buy when the market breaks below the lowest low instead. To compare like-to-like,
I optimised identical lengths, so again starting from 20-day low and ranging up to the 500-day
low. The optimisation results of this “buy low sell high” trading logic are plotted
in form of an orange line, and they are pretty interesting. We can see that there seems to
be a mirrored tendency here – as the length of the breakout level increases, the blue
line, which is the highest high breakout logic, performs better, whereas the lowest low breakout
logic performs worse. The best performing setting of the lowest low breakout system
is actually the shortest – 20 days. This period is, on the other hand, the worst performing
one of the highest high breakout system, which is the blue line.
To me personally, these results confirm a couple of things – one is that the momentum
in the markets provides an edge based on which one can develop a trading system, which can
be observed by the blue line increasing as the highest high breakout increases as well.
Second, the fact that the shortest length of the lowest low performs the best when buying
the breakouts of lows confirms the mean-revertive nature of the stock markets across shorter
time horizons. Both the momentum and mean reversion can be used as building blocks of
trading strategies, but one definitely needs to pay attention to the time horizon.
Let’s have a look a model trade of the best performing lowest low breakout system – the
one that buys the Russell 1000 stocks when the stock closes below the 20-day lowest low
price. Again, the price level used to time the trade is plotted in turquoise color, where
we can see that the level got broken on the highlighted day, meaning a buy setup got generated.
To compare like-to-like, I’m using an identical exit technique to what I used before – exit
at a trailing 10 per cent stop-loss, which is plotted in a form of an orange line. Market
hit that level on this day, meaning that the position was closed.
And now – let’s look at the equity curves and the backtest results of these two simple
systems. The turquoise line is the best performing variant of the system that buys the stocks
at the breakout of the highest high – 440 days to be precise. The orange equity curve
is the best performing variant of the system that buys the stocks at the breakout of the
lowest low – 20 days. Both systems tested from 2003 on all Russell 1000 stocks, taking
historical index consituents into the account, and both systems use the same exit – 10%
trailing stop-loss. On top of this, both systems use a simple index filter that’s based on
the Russell 1000 index and only trade when the index is above its 200-day moving average
We can clearly see that despite the orange equity curve is far more volatile, both trading
approaches seem to work and can provide a foundation for a trading strategy. A clear
pattern that emerged out of this test is that the longer term periods seem to work better
for the momentum type systems, such as the one I tested here that buys when the market
breaks above a certain price high. And conversely, shorter-term periods seem to work better for
buying the breakouts of price lows instead, confirming the mean-revertive nature of stocks
over short time horizons. Buying breakouts of longer-term price lows lead to losses in
the tests I conducted.
The actual results do not differ that much when it comes to the profitability – we
can see that the annual returns are similar. However, the drawdown figures differ significantly
– the logic of buying high and selling higher has nearly half the drawdown of the buy low
sell high logic. What I wanted to demonstrate in this video
today is that both trading approaches can work and you can use both buying high and
selling higher and buying low and selling higher as a basis for your trading strategies.
However, what I recommend to focus on with whatever you decide to take further is the
time horizons – as we’ve seen in this video, buying breakouts of the lows seems
to provide an edge over shorter-term horizons, whereas the opposite applies to buying breakouts
of price highs Thanks for watching, David at Critical Trading,
signing out