For a long time now, I have been advocating that any strategy that does not beat Buy & Hold returns is not worth following. The basic reasoning behind the said thought is the fact that Buy & Hold is the easiest way to earn money in markets and unless additional returns can be generated by trying to time the market, it makes very little sense to do anything at all and instead spend the time and effort in a venture of our choice.
But on the other had, the advantage of using a systematic strategy is that the probability of your draw-down being lower than the market is pretty high. While deep cuts do not happen at regular intervals, when they do such as in 2008, its always better to be out of the market (or better short the market) than twiddle the thumbs and hope that the markets start to react back to higher ranges.
Lets for sake of example, take a simple Moving Average Crossover – EMA of 3 crossing EMA of 5. The reason I have chosen this particular multiple is due to the huge amount of discussions that have happened previously as well as the fact that this is one of the best cross-overs among the many others than I have tested. But the fact does remain that this strategy (MA Cross is known for a very long time though much work in my circles has been done by Vish)
If I were to test the same with zero commissions and zero slippage (on Nifty Rolling Month futures from Start of Series in 2000 till date), we see that the strategy would have given us a profit of 7272 points in Nifty vs. a Buy and Hold (and ignoring for Dividends) which would have given us 6018 points in the same time span.
Since futures positions are generally created using leverage, this is not exactly a apples to apple comparison. But before we do that, lets include some transaction and slippage charges so as to make the results more realistic.
Those of whom have been trading for long would remember that its only in recent times that we have brokerage the kind Zerodha offers. I still remember paying 0.05% brokerage even in 2003 / 04. While brokerage has reduced, we now have STT to partially offset the gains from lower brokerages. Slippages too have reduced over time.
Since the back-test is being on a extremely long period of time, I would hence use a 3 times leverage with transaction charges kept at 0.03%. Now, lets look at the results once again.
The gains that we now have is close to 18750 points which comes to a bit higher than 3x of Buy & Hold. 3x of No Transaction charges would have given us 21816 points. The difference is what the cost of the transaction would equal to (on an approximate basis).
But this is not the end result either. You see, while a Buy & Hold investor has the advantage of not paying any tax on the gains (Long term gains being Zero), the same is not true for we, the short term derivative traders. The income so gained is seen as Business Income and charged under the slap which the investor comes into.
For sake of argument, lets assume that we fall under the highest slab and hence lets charge 33% of gains as tax payable. That would reduce our gains to 12562 points. Way less than what we initially started off with but still a little more than double what we could have made from a pure Buy & Hold strategy.
And what about the risk you may ask. Well, the risk (if you measure it through say Draw-down) is actually lower than Buy & Hold. While Buy & Hold would have seen you bear a max system draw-down of 60% (in Oct 2008), in the system you would have seen a max draw-down of just 18.5%, a number which is much more tolerable.
And best of all, I have not compounded my positions through the 14 year test. Even if one used a basic position sizing algorithm, I can assure you that the end result would be way higher than what has been showcased here.
Of course, what is life without some hitches along the way. While you have been a happy man in 2008 reaping your best profits even as the rest of the market was seeing blood on the streets, you would not be so happy as on date what with your strategy under-performing the markets since December of 2012 (current draw-down being 6.51% even as Nifty has moved by 1500 points in the interim).
The above trend following strategy is just a simple example to showcase how one can beat the markets even after accounting for all costs that are not accrued by a Buy & Hold investor. But that said, it also requires tremendous discipline since trend-following strategies generally tend to under-perform strong bull markets (this above strategy for example did not make a cent in the whole of 2007).
While Technical Analysis as seen on Television has been reduced to some sort of astrology, the fact remains that the true aim of technical analysis is to have the ability to reduce the risk. Once the risk of failure is controlled, its always easy to find a way to make more than what any other strategy can provide for.
Do note that I have not taken roll-over costs into account in the example above since I believe that the probability is high that over such a long period of time, roll-over costs shall cancel each other out (since we also take and rollover Short positions). But that maybe something to test some other time 🙂