The market action since July has been a great test for the Quantum Fading system. We have seen a ‘crash,’ whipsaws, and then a big rally. I tend to classify market scenarios into 6 different categories.
The market can move either up, sideways, or down. And for each of those moves it can move in either a straight line or get there with reversals (I loosely use the term volatility to describe reversals and whipsaws).
- (A) Strong uptrend with little volatility: QF will not profit if no positions are open
- (B) Strong uptrend with volatility: The ideal scenario for QF. Very little cash (1 position of 4) is used to generate profits.
- (C) Sideways market with volatility: Another good scenario that will generate profits if there is enough volatility.
- (D) Sideways market with no volatility: Rarely happens, but if it does, no trades will be made and there will be no gain or loss just like the market.
- (E) Bear market with volatility: Volatility usually accompanies bear markets, and if there are big enough dips and pops in the overall downtrend, the QF system should break even.
- (F) Bear market with no volatility: The worst case scenario for QF. No profits are made, and positions are not sold until the market finally bounces.
In the beginning of August there was scenario F. Then mid-August to end of September was scenario C. Aside from some very small pullbacks, October has been scenario A.
The performance of Quantum Fader (QF) can be compared to the market in these 3 scenarios. XLE is used since it is a good approximation of ERX’s underlying index (ERX actually uses Russell 2000 Energy Index, but XLE is close).
Scenario F (Crash)
When the market dropped hard in August the QF system scaled in all 4 positions until it was 100% equity by the time the bottom was reached. Due to the use of the leveraged ETF ERX, at the bottom QF was hurt more than an equivalent 100% investment in XLE.
Scenario C (Whipsaws)
However once the market stopped going down and instead had whipsaws going sideways, QF was able to profit 6.5% from these reversals even though XLE ultimately dropped another 9%.
Scenario A (Rally)
When the market started rallying in October, QF had all 4 positions invested (100% equity). It scaled out of those positions on the way up. The last time a rally this strong happened in such a short period of time was 1987.
Scenario A is great for QF, but if the market rallies long enough non-stop without pullbacks, QF will eventually scale out of all positions and will not capture the tail end of the rally. Even though QF missed the last part of last week’s rally, it rode enough of it to see an increase of 32%.
Here is a chart showing the profit or loss of each QF position through these 3 market scenarios.
The whipsaws resulted in profitable trades. This is typically how QF works. QF will suffer drawdown upon market crash, but typically makes up for those losses due to the heightened volatility at the lower levels.
QF is currently sitting 100% in cash waiting patiently for a small pullback to open a 25% position. The system will continue the usual pattern of buying dips and selling pops, thus ‘fading’ the market. It is important to study the 6 market scenarios in order to understand the risks of trading using QF. In a nutshell, the biggest risk for QF is a multi-day market crash with no reversals. The deeper it goes, the longer it will take to recoup the drawdown by profiting from market swings at the lower levels.