I’ve decided to trade a 50/25 Long-Only Donchian Breakout system on XIV, despite the fact that an Oscillator based system on VXX resulted in better risk/adjusted performance (long/short systems), simply because the brokerage I use does not have shares of VXX to short. The rules of the system are simple:
Buy: The close of today is higher than yesterday’s 50-day high of the close.
Sell: The close of today is lower than yesterday’s 25-day high of the close.
I use a 20% stop loss. This system was visually optimized, meaning I looked at the chart below while adjusting the parameters and chose parameters with round numbers that seemed to have the best risk/adjusted returns.
Here are the results of the system based off of the simulated data from above going back to 3/26/2004 and ending in 11/26/2012:
I’ve allocated approximately 25% of my capital to this system. Friday afternoon (11/23/2012) a buy signal was generated. I bought 150 shares on the following Monday using a limit order, and managed to get filled at 18.65. I plan to follow this system until it experiences an 80% draw-down. In the future I will create a long only VXX system to use while this system is in cash.
There are two arguments against this system (or similar systems) that I’ve found:
1) 1987 style crashes will eat all the profits, and then some, that this system has generated. Found at Six Figure Investing’s post: “A Brief History of Fear.”
2) There is too little data to tell. The data dating back to 2004 only shows one current regime. According to user Damian Bergamaschi, a commenter on the post “Alpha Strategy” at Don’t Fear the Bear, “My findings show that the years 00-jan03 the market spent more days backwardated than in contango and 96-98 was almost the case as well.”
1) I can’t think of any reason not to be worried about this. I can only hope that my system will somehow exit before a crash of this magnitude. While the possibility of a crash of this magnitude happening within a day is slim, history has proven that it is still a possibility. If someone has an idea to safeguard against this, please share 🙂
2) I don’t think that a market with more contango than backwardation is only a regime. I think the markets have fully incorporated the fact that if there were as many days in backwardation as there is in contango, than investors could generate alpha relatively easily by using VIX-ETPs as a hedge. I could be wrong, but even if I am, the exit on a 25-day low should prevent the system from losing too much money in a backwardation environment.