This post is the fourth in the series explaining the Dynamic Momentum Trading  ETF rotational system. The focus here is to discuss an option that may be used to trade the Dynamic Momentum Trading System (DMS).

Earlier posts should be read prior to this one. Click here for Part I, Part II, Part III. Trading choices, backtest results and risk are dealt with in these articles. 

SSS “System”

The SSS, Simple Switching System, is not a system per se. It is an indicator that can be used in conjunction with the DMS options. It need not be.

The SSS is a proprietary momentum oscillator specifically designed to be used with DMS. It is an option for users. It is calculated weekly and registers as “GO” or “STOP.” Favorable momentum readings require no change to DMS positions. Unfavorable ones may be used to alter the DMS trade (eg. lighten up the position or close the position).

Use of the SSS enables a user to modify risk of trading the DMS. It lowers both risk and, in most cases, profit.

SSS need not be used strictly. The DMS produces ETF rankings each month. The SSS produces its readings weekly. DMS users can use SSS strictly or intuitively. That is, they can always follow SSS signals to modify DMS or selectively choose when to do so.

To assess the effects of SSS, backtest results are conducted and presented below. Two results are shown. For both, all SSS signals are executed. Users of DMS can elect either version of SSS or to utilize SSS along with intuitive feel to modify DMS.

Two Versions of SSS

The first version of SSS, call it SSS1,  assumes exiting a DMS trade and going to cash when the signal reads stop or Red. When the signal returns to go (Green), DMS is only re-entered on a trade day (see earlier articles). Essentially, that means that exits occur immediately but re-entries occur only once per month (on a trade day).

The second version of SSS, SSS2, is identical to SSS1 with respect to exiting a DMS trade. It differs only in re-entry which occurs whenever the signal turns Green. It enters on any day, not just a trade day. Because DMS systems are more profitable when not using an SSS filter, getting back in sooner may be a favorable compromise between trading DMS only or DMS with an SSS filter. This issue is an empirical one that backtesting can help with.

The backtest trading results for each SSS are shown below.

SSS1 Backtest

SSS1 — Strict

As in previous articles, Style reflects Normal, Aggressive and Conservative shown as 1, 2, and 3 respectively in the Style column. Pos represents the number of DMS rankings traded.

Both tables have a few new columns that the previous DMS tables did not (see Part I). The new columns pertain to market exposure. Market exposure is defined as the percentage of time a system is in the market. The DMS systems are virtually 100% invested all the time. The SSS1 and SSS2 systems are not. They switch between the selected DMS system and cash. Thus, they are not subject to market exposure all the time.

The following comments explain the new columns:

• In  the table above, DMS is in the market just over 50% of the time (Exp% column).
• That necessitates an additional column, RAR%. This column adjusts the CAR% (compound annual return) to what its equivalent might be if the funds were invested 100% of the time.
• RAR%/Big Sys represents the adjusted CAR in terms of the maximum drawdown (Big Sys Loss).

Other columns are unchanged from earlier tables.

SSS2 Backtest

SSS2 — Easy

SSS2 is less strict (easy) on re-entry, re-entering any week not just a trade day. Thus, it has higher market exposure (more than 60%) than SSS1, trades more and produces higher overall profit. It does so with the same maximum system drawdowns as SSS1.

Note on Number of Trades: The number of trades is understated in the tables above. What is represented is the number of trades between the DMS system and cash. If you are trading a DMS system and remain in the system say for 4 months and then go to cash, the above table will show that as two trades — one to get into DMS and one to go to cash. The reality is that you might be adjusting your position(s) each of the four months in the DMS system. These trades are not reflected above. In this example, what shows up as two trades could be as many as five. Trading more positions in a DMS system aggravates further the understatement of true trades. There is no easy way to make this calculation but you should be aware of it and its effect on transaction fees.

SSS vs DMS Backtest Results

Comparable full tables to those above can be seen for DMS tests in Part I of this series. These should be used for a complete comparison. For purposes here, only a few select metrics will be compared.

1. CAR%/Maximum Drawdown — Slight Advantage SSS

Using percentage returns related to maximum system drawdown — CAR%/Biggest system drawdown (a relative return to risk ranking), the SSS results dominate. The five best DMS Long Only returns are between 1.2 and 1.3. The five best SSS1 measures are between 1.0 and 1.5. SSS2 metrics are even better: 1.1 – 2.1.

2. RAR%/Maximum Drawdown — Dominant Advantage SSS

DMS measures are identical to the CAR%/Maximum Drawdowns because these systems are invested 100% of the time. SSS1 range from 1.9 t0 2.8 and SSS2 from 1.6 to 3.3.

3. Maximum System Drawdowns — Dominant Advantage SSS

Twelve of the eighteen SSS bactests have drawdowns of 12.8%. The best DMS system has a maximum drawdown of 20%.

4. Sharpe Ratio —  Slight Advantage SSS

SSS outperforms slightly DMS.

5. Total Profits — Dominant Advantage DMS

Single position DMS systems dwarf the profits produced by SSS.

6. Profitability — Slight Advantage DMS

DMS has higher compound annual returns (CAR%) than both SSS1 and SSS2.

SSS systems dominate DMS in terms of RAR%, but that is meaningful only if you have an option to invest the cash at comparable returns when you are out of the market.

Summary

Comparing the DMS only system with the DMS filtered by SSS, the SSS system produces better returns to risk calculations  ( 1 – 4 above). DMS clearly produces dramatically more profits (number 5). It dominates in compound annual return % but falls short on RAR%. (RAR% is meaningful if you have alternative comparable investments for the cash.)

Once again, it comes down to risk aversion. Do you prefer a lower, likely safer, return to a higher, riskier, one? Dynamic momentum trading coupled with the SSS screen enables you to modify your risk-return trade-off.

In Part V of this series, the SSS indicator will be used with the DMS rankings. This focus will allow users to see how simple it is to integrate into a trading style. Look for this (hopefully) final part in the next week or so.