September 2020 Performance Report

Industry Benchmark Performance

Smaller losses for the hedge funds compared to the benchmark equity index markets. Performance remains in-line with the DOW index more than any other. Most CTAs are positive for the year, a good offset to equities. Given all the negative news, breaking even seems to be a good return.

Blogs and Recent Publications – A New Book on Amazon!

 “Kaufman Constructs Trading System” has gotten excellent feedback. Thank you! You can find it on Amazon or on our website, www.kaufmansignals.com.

Find recent publications and seminars at the end of this report. We post new interviews and reference new articles each month.

Kaufman’s Fast Strike Systems on MetaStock

If you are interested in short-term trading, look at Kaufman’s Fast Strike strategies. Contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana.

September Performance in Brief

A losing month was inevitable, and September shows losses in all programs. The daily and weekly Trend programs did better than the S&P, and we exited both the daily and weekly Trend programs on the open of Friday, September 4. We are still out of the market based on high risk and negative returns, but expect to reenter soon.

Our programs still hold very attractive year-to-date returns and, given that we are reducing risk by being out of the market in some programs, the reward to risk ratio for investors will be good.

Major Equity ETFs

Have the index markets posted a top? Is it just another pattern to fool investors? There is no way to know. The market has been driven by tech stocks and those benefiting from consumers staying at home. Those stocks: Apple, Amazon, Tesla, Walmart, and others, are such a large part of the index that they can distort our view of the economy. And we know that the stock market does not represent the economy.

We see that QQQ has traded off its highs more than the other index markets, after having gained more. According to the chart, the other three index markets remain below the highs before the covid crisis, with the small caps (IWM) doing the worst. Classic analysis says that during times of uncertainty, investors seek the larger, more stable stocks represented by the DOW. Well, except for NASDAQ!

CLOSE-UP: Selling Volatility

This month we anticipate high volatility due to uncertainty from many directions: covid disruptions, layoffs, and the anticipation of the election. Volatility is not desirable for most traders and fund managers, but some have profited from selling volatility, a common strategy for professionals. Let’s look at how to measure volatility and how traders use that to generate profits.

Measuring Volatility

There are three popular ways to measure volatility, and each are used for different purposes.

  1. Annualized volatility is used by the financial industry and is the basis for options pricing. It is normally calculated over the past 20 trading days, using daily returns, as:

AVOL = stdev of returns over the past 20 days x sqrt(252)

where the sqrt(252) converts daily volatility to yearly. Because it is based on only 20 days, some values can be greater than 100% when daily is converted to yearly. That does not affect the way it is used. It is very good for filtering trades that have extreme volatility.

2.  Average true range, uses the daily high – low range extended by the close of the previous day if there was a gap open (called the true range), then averaged over 20 days

True range = max(high(t) – low(t), high(t) – close(t-1), close(t-1) – low(t))

Average true range (ATR) = average(true range,20)

The ATR is the best choice for calculating position size in futures. We use the investment divided by the dollar value of the average true range to get a position called “volatility parity.”

3. VIX is the implied volatility of the S&P futures over a number of strike prices and expirations dates. It is the implied volatility based on what traders are willing to pay for the options. Given the price of the option, we can solve for the implied volatility. VIX is traded as the ETF UVXY. It can rise quickly when there is uncertainty, then fall just as quickly.

Figure 1 compares the three measures based on SPY, the S&P ETF. SPY is at the top, the ATR in the second panel, AVOL in the third panel, and VIX at the bottom. Note that AVOL is smoother than VIX and has a lag because it uses the last 20 returns. The ATR appears more erratic, but the extreme points are the ones of interest.

Figure 1. SPY with three volatility measures: ATR (second panel), AVOL (third panel), and VIX at the bottom, starting in 2020.

Selling Volatility

You can see from the three volatility measures, in the lower panels of Figure 1, that volatility spends most of the time at low values with occasional spikes. That has caused the bulk of the trading to be short sales. A simple strategy can take advantage of this short bias.

VIX vs UVXY

The VIX index in not tradeable, but the ETF UVXY is tradeable. However, it is not always the same as VIX. Figures 2 and 3 show the difference. When there is an unexpected event, both VIX and UVXY will move together, as shown in Figure 2. In this case, UVXY peaked higher than VIX.

Figure 2. VIX and UVXY from January 2020

On the other hand, when traders are positioning ahead of an event, they will sell UVXY, causing it to peak much lower. Figure 3 shows the British election on December 12, 2019.  The rally in the VIX index was 29% while UVXY only rallied 9% due to advanced selling pressure. The opportunity for profit in UVXY will change based on whether or not the event was anticipated.

Figure 3. VIX and UVXY around the British election on December 12, 2019. Selling anticipation greatly dampened the rally in UVXY.

If we add the number of days that each market traded lower, we get 54% for VIX and 60% for UVXY, confirming that there is bias to the short side. In this case, that bias is increased by traders.

Selling High Momentum

There is a simple trading method takes advantage of the downward bias of UVXY. The rules are:

  • If UVXY is lower for two days, then sell a lower open the next day. If it does not open lower, then sell a lower close.
  • Once entered, exit in three days on the close.
  • Taking profits on a fast move down should increase the number of good trades as well as the net returns.

This is “high momentum” strategy because we are taking advantage of a downward move to sell, expected prices to continue lower. It is the opposite of an overbought/oversold momentum system and unique to VIX. Applied to UVXY from September 2014, Figure 4 shows the history of returns. This strategy was not optimized, so you may be able to improve results by introducing profit taking, a stop-loss, a volatility filter, or adjust the entry and exit days.

Figure 4. Returns of UVXY high momentum strategy from September 2014 when UVXY began trading.

There were 219 trades, of which 63% were profitable. There was a maximum of 12 consecutive profits and 6 consecutive losses, and an annual rate of return of 14%, although most of that was in the early years.

If you have been a short seller of options, then you should know that the profile of returns is very similar: many small profits and a few big losses. There is no way to change that pattern.

A Standing Note on Short Sales

Note that the “All Signals” reports show short sales in stocks and ETFs, even though short positions are not executed in the portfolios. Our review of using inverse ETFs to hedge stocks during a decline showed that downturns in the stock market are most often short-lived and it is difficult to capture those moves with trend systems. This confirms our approach to the Timing systems, which hedges up to 50% of the long stock risk using multiple trends. In the long run, returns from the hedges are net losses; however, during 2008 the gains were welcomed and reduced losses.  In any correction, we prefer paying for risk insurance, even without the expectation of a net gain.

Portfolio Methodology in Brief

All the programs — stocks, ETFs, and futures — use the same basic portfolio technology. They all exploit the persistence of performance, that is, they seek those markets with good long-term and short-term returns, rank them, then choose the best, subject to liquidity, an existing current signal, with limitations on how many can be chosen from each sector. If there are not enough stocks or futures markets that satisfy all the conditions, then the portfolio holds fewer assets. In general, these portfolios are high beta, showing higher returns and higher risk, but have had a history of consistently out-performing the broad market index in all traditional measures.

PERFORMANCE BY GROUP

NOTE that the charts show below represent performance “tracking,” that is, the oldest results are simulated but the newer returns are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted.

Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks, including Sector Rotation, Income Focus, and Dow Arbitrage

The Trend program seeks long-term directional changes in markets and the portfolios choose stocks that have realized profitable performance over many years combined with good short-term returns.

The Equity Trend Program has had a good run of profits and has benefited from the extreme risk rule that exits the portfolio with a combination of high risk and negative returns threatens performance. The program salvaged a good amount of profits earlier in the year and has now been out of the market since September 8. Volatility remains slightly above our threshold while prices jump up and down. We can reenter whenever volatility declines, which we expect will be soon.

Income Focus and Sector Rotation

The Daily Income Focus program is holding steady while the Weekly program shows a pattern of recovery from its recent sell-off. Overall returns this year are low due to the record low interest rates that have previously been used to offset any losses.

Sector Rotation

After a few good months, the Sector Rotation program took a 10% loss in September. Overall, this strategy, considered a classic way to move money between sectors, has been a disappointment. We continue posting it because it represents a strategy that has been used for years and may again become successful.

DOW Hedge

We like this program because it trades the largest cap stocks and has recovered quickly from drawdowns. This month it lost over 6% but is still higher by over 12% for the year, while the DOW ETF, DIA, is actually lower for the year by 1.4%. The strategy of buying the strongest of the DOW stocks takes advantage of persistence, which is also the basis for our other portfolios.

Group DE2: Divergence Program for Stocks

The Divergence program looks for patterns where price and momentum diverge, then takes a position in anticipation of the pattern resolving itself in a predictable direction, often the way prices had moved before the period of uncertainty.

The loss of 3% to 4% for the Divergence program is small given the run-up over the past few months. The 10-stock portfolio has far exceeded the more conservative 30-stock portfolio, 32% compared to 15% for 2020. But both returns are better than the S&P.

Group DE3: Timing Program for Stocks

The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. Its primary advantage is that it does not depend on market direction for profits, although these portfolios are long-only because they are most often used in retirement accounts.

This program, which buys undervalued stocks compared to its related index, has been the big performer for 2020, up 51% and 61% for the 10 and 20-stock portfolios, after this month’s loss of between 1% and 2% for the program. There is no way of knowing whether this strategy will continue to outperform, but the concept is sound.

Futures Programs

Groups DF1 and WF1: Daily and Weekly Trend Programs for Futures

Futures allow both high leverage and true diversification. The larger portfolios, such as $1million, are diversified into both commodities and world index and interest rate markets, in addition to foreign exchange. Its performance is not expected to track the U.S. stock market and is a hedge in every sense because it is uncorrelated. As the portfolio becomes more diversified its returns are more stable.

The leverage available in futures markets allows us to manage the risk in the portfolio, something not possible to the same degree with stocks. This portfolio targets 14% volatility. Investors interested in lower leverage can simply scale all positions equally in proportion to their volatility preference. Note that these portfolios do not trade Asian futures, which we believe are more difficult for U.S. investors to execute.

Using the same strategy and portfolio logic, the Weekly Trend Program for Futures has the added smoothing resulting from looking only at Friday prices. While it will show a larger loss when the trend actually turns, most price moves are varying degrees of noise which this method can overlook.

Please read the report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”

Even with losses of 2% to 8% (smallest to largest portfolio), this program is far outperforming its peers. It remains higher by 15% to 20% for 2020.

Group DF2: Daily Divergence Portfolio for Futures

This program continues its pattern of ratcheting higher, with losses of about 1% for September in all portfolios. Year-to-date is marginally profitable for the three portfolios.

Blogs and Recent Publications

Kaufman Constructs Trading Systems

You will find both an ebook and a print version of Perry’s new book, Kaufman Constructs Trading Systems, published on Amazon. It is a complement to Trading Systems and Methods. It takes you step-by-step through the process of developing a trading system, with many examples. Order it through our website, www.kaufmansignals.com or directly on Amazon.

Trading Systems and Methods, Sixth Edition

The sixth edition of Trading Systems and Methods was released the last week of October by John Wiley. It is completely updated and contains more systems and analyses.

MetaStock Strategies

MetaStock issued an upgrade to the Kaufman Fast Strike add-on in late January. This add-on has three short-term trading systems, holding positions for one to three days in two of the programs, and about one week in the third program. They trade noisy markets, including most major index ETFs and futures, plus one program trades the VIX. You can see a description of the programs and a record of past performance on MetaStock. Anyone interested should contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana

October 2020

Mr. Kaufman will be presenting in a webinar for the Indian Technical Analysis group in Mumbai on October 3. The presentation will be geared towards beginning to intermediate traders. You can find more at https://www.algoconvention.com/schedule

On Saturday, October 10, Mr. Kaufman will be interviewed for The Systematic Investor Podcast, discussing risk.

On Thursday, October 22, he will be conducting a seminar for the clients of Fineco, a large Italian bank.

On November 1, Mr Kaufman will be interviewed by Andrew Swanscott for his podcast, Better System Trader. He will try to anticipate the reaction to the coming election.

September 2020

“Fools Rush In,” an analysis of the best time to buy an IPO, will be published in the September issue of Technical Analysis of Stocks & Commodities. There is also a full description of Kaufman Constructs Trading Systems in the “Books for Traders” section.

June 2020

Mr. Kaufman gave a presentation at Jake Bernstein’s “Cycle” seminar. Anyone interested in a copy of the presentation should send a request to kaufmansignals@gmail.com.
The June issue of Technical Analysis of Stocks & Commodities published the article “Crashes and Recoveries.” It will help you figure out how the Covid-19 pandemic will play out. It will also have the TradeStation code for the “2nd Cross” strategy, requested by readers.

March 2020

There are some comments in the April issue and on the current stock market drawdown and a correction to Mr. Kaufman’s article in the March issue of Technical Analysis of Stocks & Commodities

February 2020

“The 1st and 2nd Cross” was published in Technical Analysis of Stocks & Commodities in the March issue. It is based on an idea of Linda Raschke and captures small but reliable pieces of a trending move.

January 2020

A new article “Essential Math For Traders” will be published in the Bonus 2020 issue of Technical Analysis of Stocks & Commodities.

ProActive Advisor Magazine (on-line) published “Controlling risk that doesn’t go away,” posted on January 15.

Both of these articles are important for understanding your investment risk.

December 2019

Technical Analysis of Stocks & Commodities published an interview with Mr Kaufman in the December issue.

MetaStock Seminar held in Sunnyvale

Mr. Kaufman was a keynote speaker at the MetaStock conference in Sunnyvale, November 3. You can hear this presentation by going to the MetaStock website.

November 2019

Technical Analysis of Stocks & Commodities published “Running for Cover,” an article by Mr Kaufman that looks at whether buying bonds after a sudden drop in the S&P can still be profitable.

Book Interview

Mr. Kaufman appears as a chapter in Mario Singh’s book, Secret Conversations with Trading Tycoons, published by FXI International.

Older Items of Interest

For older articles please scan the websites for Technical Analysis of Stocks & Commodities, Modern Trader, Seeking Alpha, ProActive Advisor Magazine, and Forbes. You will also find recorded presentations given by Mr. Kaufman at BetterSystemTrader.com,  TalkingTrading.com, FXCM.com, systemtrade.pl, the website for Alex Gerchik, Michael Covel’s website, TrendFollowing.com, and Talking Trading.com.

Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical and was a keynote speaker at the 2018 IFTA conference in Kuala Lumpur, both last October. You should be able to get a copy of the presentations by MATA, the Malaysian Association of Technical Analysts.

 “In Search of the Best Trend” was published in Technical Analysis of Stocks & Commodities in July 2019. An article on “Defense is Your Best Defense” will appear in ProActive Advisor Magazine also appeared in July 2019.

Mr. Kaufman was a keynote speaker at a number of IFTA conferences, the most recent in 2018 in Kuala Lumpur, and Milan in 2017. You can find his presentations on their website.

You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to perry@kaufmansignalsdaily.com.

© September 2020, KaufmanSignals. All Rights Reserved.

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