Building a Trading System: Part 6–Volatility (cont.)

As mentioned early on, this series is not for the trading system experts, but for those getting a taste of systematic trading early on. I reiterate that here because I’m talking about some fairly basic topics. Most of the quantitative traders out there with any experience have a pretty good handle on these ideas.

In the last post I introduced the idea of volatility. As discussed, we are adding to our theory on mean reversion, that volatility is a good thing. With that said, I’ve inserted a line of code into our previous formula to filter using HV10. In other words, I want to see what happens when I only take trades on higher volatility stocks. Here’s the code with the update:

Buy =

HV10 > 50 AND

Close < MA(C,5) * 0.95 AND

Close > MA(C,200);

Sell = Close > MA(C,5);

So how did we do?

First, let me mention that I picked 50 (the number for HV10 to beat in the above code) somewhat randomly. I first ran a report of all the trades from the previous screens and it showed be the HV10 value for each one. I then just eyeballed the list and 50 looked like a good number to use to split the list… that is, it seemed higher. Here’s how it looked:

Column C is the new column added on to the previous posts. As you can see, the system seems better in nearly every category. Drawdown is up a smidge, but I like the improvement everywhere else. Of particular interest to me is the improvement in Sharpe ration and Average return per trade. Notice we took out nearly 600 trades without lowering the return at all. We took out the ugly ones!

The equity curve improved nicely. It still shows some choppiness in 2004, but generally it’s much better than before.

Again I want to stress, I do not trade this system, and do not recommend that you do. This information is purely instructional. It’s very easy to get excited about numbers like you see here, but there are tremendous risks.

In the next post, we’ll take our very basic working system and look at optimizing it. I won’t spend a lot more time developing the system, as this should give you a pretty good idea of the process. There is much more we could do, but that’s not the main point of this series. Instead, we’ll move on to the next steps in the process.

Good Trading…