Quantum Trading

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).

1. (A) Strong uptrend with little volatility: QF will not profit if no positions are open
2. (B) Strong uptrend with volatility: The ideal scenario for QF. Very little cash (1 position of 4) is used to generate profits.
3. (C) Sideways market with volatility: Another good scenario that will generate profits if there is enough volatility.
4. (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.
5. (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.
6. (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.

YTD Performance
QF: +20%
XLE: +7%
S&P500: +2%

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.

The energy sector got absolutely crushed today. XLE was down 5.64% versus the S&P’s 3.19%. Energy has been slammed since the July peak as it is now down 25% to the S&P’s 16%.

The QF system opened position #4 of 4 again, going ‘all in.’  It is not because the system is bullish, it just happens that way when the market goes down big. Just like on August 8 where position #4 was opened and the market bounced the next day.

If the market keeps going lower, no more positions are opened. Instead the system uses ‘phantom’ positions to calculate when to scale back out of the existing positions.

It did not take long to get back down to $42 again. The position that was sold up near $48 was re-opened at this lower level. We have been trading in a range for around a month now, it is hard to imagine a break to the upside. But even on the downside it seems a lot has already been priced in. However, as always the market can always go much further in one direction than people usually anticipate. I am hoping we break to the downside and thrash around in the $30′s with high volatility.

This recently opened position at $42 will be sold in the mid to upper $40′s, but if the market tanks, the next position to open will be if ERX gets down to the mid to upper $30′s.

A position was closed today. Got in a few days ago at $42 then out at $48. Now there is plenty of cash on hand should the market tip lower in the next few weeks. Alternatively, if the market slowly ramps upward, there are two other small positions still open to ride it up. Unless some big news happens, we will probably be in a range for a while. If that is the case it might be a few weeks before the next ERX threshold is hit (mid $50s or lower $40s).

As the ’tsunami’ was discussed on 8/12 (the economic aftershock of the market), we got one of the massive economic misses to the downside this morning (Philadelphia Fed). That set up for another big day of volatility. It would be no surprise if more bad data comes, as the market is pricing it in. The question just becomes how much will it miss. Alternatively if data surprises to the upside it could result in a short squeeze.

Whichever the case, Quantum Fader is still plodding along. With two profitable positions sold off the recent bounce, that provided capital for re-opening a position at a much lower level today. To me it seems either direction in the market is a positive: further downside means more volatility and potential for profits, and upside would mean profits for the position just opened.

Quantum Fader closed another position today. It is more of the same, scaling in on the way down, scaling out on the way up. If there is enough churn in between, it means profits. The next sale will be in the upper $50′s.

Back in May 2010 we had the flash crash (due to the European debt crisis and Greece riots). Prior to the stock market turmoil, the economy was plodding along. But after the shock of the volatile market, the economic data took a big turn for the worse by the time middle summer came around. The market had the bad ‘future’ data priced in by the end of May, so even when data got much worse in June, July, and August, the market just thrashed sideways.

I am very interested to see if the same scenario plays out again. The economy was by no means growing fast this summer, and things were starting to slow a little, but this latest market crash may have sent another shock to the economy. By that I mean I would not be surprised to see ‘surprising’ negative data. I would think after this recent crash that economists’ expected numbers would decrease. We will see if the bar is set low enough, or if things get much worse than expected. I would have to think that a lot of bad data is already priced in, but the million dollar question is “how much?”

It almost seems like these events are like earthquakes and tsunamis. First there is the shock, which is the violent crash in the market. Then, slowly, as the market whipsaws sideways, the slow moving massive wave of bad data sweeps over the economy. Then at the end of the bad economic data come the poor jobs numbers (which everyone says is a lagging indicator, but they love to use it for saying how bad the future will be).

My opinion of the market is that unless there is some kind of paradigm shift, a catalyst to change investor perceptions, the market will not go above 1250. In other words, without unexpected positive data or fed intervention I do not believe normal market activity can get us above that number. That will be my prediction #005.

Quantum Fader Update
The system closed position #4 today for a nice profit. There are 3 other positions waiting for further upside before each one is closed due to thresholds being met. Unfortunately, the Tuesday/Wednesday pop then drop was missed by the system. Technically, QF was supposed to sell at the end of Tuesday. But, at 3:55 PM the upside threshold was not reached. However in the last 5 minutes ERX skyrocketed another 3-4 percent to cross the threshold. So, even though the system is now ‘re-synchonized,’ Tuesday was a missed opportunity to profit from volatility. At least Thursday’s pop was caught. 

Stocks have been hit by 3 punches, and fear has taken over.

1. Debt negotiations
2. European debt crisis
3. USA credit downgrade

These 3 items have pushed the market (and the energy sector) into a downward force not seen since 2008. The credit downgrade has some subtle but nasty effects. Not only does it raise the usual fears of rising interest rates, but it also means investors may think the probability of QE3 is now less likely to happen. I believe it will take a paradigm shift for us to get a bounce (i.e. government intervention).

These types of market events are rare, right?

Actually, it happens in the energy sector more than one might think. Over the course of a few weeks each time, XLE was hammered in 2001 by the Sept 11 attacks (-19%), then again in 2002 (-24%), and even in the beginning of 2008 (-17%). Quantum Fader has been tested against a hypothetical 3x version of XLE to see what happens during these periods and the volatility that followed. Thus, while it is certainly short term pain, especially when ERX is down 11 straight days in a row, my faith lies in QF’s simple algorithm to produce profits from volatility over a longer time horizon (several months or more) to eventually make up from this short term drawdown.

Obviously there are no guarantees. The only thing to go by is backtested results on previous crashes using a hypothetical 3x of XLE. Let’s consider 2002’s July crash where XLE dropped 24% over the course of 11 days.

The system scaled in on the way down, and actually had horrible timing as it was completely scaled in (100% invested) by the time ERX (3x XLE) was only down 12%. This is the ‘bad case scenario’ that really hurts the drawdown. As the market kept dropping, QF was unable to open more positions due to lack of cash. It eventually bottomed out once XLE reached -24%, and QF was -47%. Currently QF is 100% invested while XLE is down 21%.

In the volatile sideways months that followed, QF made enough trades to recoup all losses and get back to break even by the end of the year even while XLE was still down 12%. Please see the following newsletter (it is on the subscriber FTP) for more examples of drawdowns and hypothetical QF performance:

2011.05.30.QF.Newsletter.pdf

Disclaimer: These results are hypothetical and have not been tested by an independent party.

It is important to note that not everyone has the same level of risk that they are willing to accept. Strategies and portfolios are often recommended to be diversified. The QF strategy is provided so that traders optionally have a way to potentially profit from volatility. I have tried to provide enough information such that traders can ‘make it their own’ to increase or reduce risk. My door is always open for questions so feel free to contact me at kevin at (this website, which is quantumfading.com).

The second half of 2011 will like have many swings and surprises, and I am ready for the ride.

It turns out prediction #002 was correct. That doesn’t mean much however as I didn’t make a trade off of it.

Everyone is waiting for the snap back rally. And when it keeps going lower it keeps hurting more and more. I think we are close to the point at which there are no more sellers, and it is so scary noone wants to jump in. My next prediction is:

#004 – When things calm down, we will see a slow rise in the market, not a big bounce.

Probably almost everyone now believes we will be entering another recession. The market built it in in just a few days. If SPY reached 117, that would be a 13.5% drop which is close to 2010′s summer downturn when everyone thought we were going to double dip (then QE2 came). Obviously the big question now is how deep we go.

Investors might look at the USA debt downgrade and now think QE3 is less likely. Hence, Monday futures are down big. All I know is that I am looking forward to the volatility. Short term pain, but long term gain.

As I suspected, the energy sector gave up its outperformance the past 2 days. Now it is back to more normal levels relative to the S&P (for the year).

The QT system opened a position intraday at $60 while the end-of-day QF system opened one near the close below $54. These types of drops in the market are more common than one might think. Granted, this one happened in just a few days instead of a few weeks. But, QF has been tested through market conditions such as these. In fact, this drop is small compared to two drops in 2001 and 2002. In 2002 the energy sector dropped 30% over a short period, and RSI(14) went below 15. Currently it is ‘only’ 26.22.

Many are expecting a snap back rally due our oversold condition. I actually have my own predictions for the market in its current state:

#001 – The market is not going to snap-back rally (> 3%). I think we will thrash around these levels for a while.
#002 – A positive Friday job report will result in a positive premarket that will be sold off to neutral. Rising dollar?
#003 – A negative Friday job report will result in a negative premarket that will be bought to neutral. Built in, and QE3?

I don’t have any concrete plans for trading these predictions, but, if the market opens low tomorrow, QT is due to open another position. Regardless if the predictions are right or wrong, if one intends to trade the market, it is good practice to consider all of the scenarios ahead of time so one isn’t caught off guard.

The European debt crisis has investors spooked as many probably do not want to get burned like in 2010 after the flash crash. Hence, I think it is unlikely much risk will come back on the table in the near term. Unless of course QE3 is announced and there is a short squeeze. Or if there is some other catalyst.

I am looking forward to patiently scalping some volatility trades to make a few bucks. The market doesn’t go in one direction forever. (It might have felt like it in 1987, though).