To start the year, we like to take a step back to review what it is we’re really trying to do at the various levels of our life. At a high level, what we want from our trading decisions is to be out when the market is down, without missing the gains when the market moves.
I saw this illustrated perfectly with a simple chart that featured the last 18 years of the S&P 500. The chart compared the index against where it would be if we took out the 10 best days, as well as the index where the 10 worst days are taken out. This chart is recreated below, simply revising those days to ‘unchanged’
Beginning with the green line, we have the S&P 500 or ‘buy and hold’ the index ending on this chart at 2,001.78. In comparison, the blue line shows that by taking out the 10 best days, the price ends up 30% lower (1,388.31). The red line shows an even more dramatic difference, when taking out the 10 worst days, that the price ends up 40% higher (2,793.3).
As you can see, just 10 days made a huge difference in the end result. This is of course, rather over simplified, but we can learn some key lessons from this thought experiment.
The blue line illustrates, in a way, the equity curve of a net loser in the market. Fear drives him out of the market, only to miss the biggest opportunities. In reality, this line could also represent the greater fool, who watches from the sidelines as others make money. When he finally can’t stand it anymore and buys, he catches the top and holds the loss without any risk management discipline. The difference between the where the green & blue lines end up represents the negative effect of poor intervention.
The red line, alternatively illustrates in this example, more what we strive to be like. This line assumes market exposure for all the gains, but avoids the major loss days. By evading just 10 of the biggest down days of the last 18 years, we see there is another huge pocket of opportunity. This doesn’t represent ‘creating’ any sort of opportunity. It simply takes advantage of what exists in the market, and is out when the market takes away.
As ambitious traders, we want to not only capture all the opportunity, but also squeeze more out by compressing the time horizon, by making responsible use of leverage, and by shorting breaks in asset prices. We look forward to diving further into these topics over the course of this year, but to start, let us seek first to do no harm & second to manage risk in what is looking like a very dynamic & volatile year.
To close today’s post, above is sample chart from AbleTrend, featuring the densest period of market down days from our 10 worst days of the last 18 years, back in 2008.
Jesse