Baseline for Active Investing

Today's author is Jackie Ann Patterson, the editor of BackTesting Report. Previously Jackie Ann showed us how to pick up on a potential trend change as well as how to recognize a mature trend using the MACD indicator. Today she has returned to the Trader's Blog to share a method for testing your trading strategy.

----------------------------------------------------------------------------------------------------------------------------------------------------
One of the ways that traders use to determine the success of a potential strategy is to use a baseline. A baseline is a benchmark or a standard for comparison. For example, some investors will use the gain/loss of the S&P 500 as a baseline of market performance. That may be useful for investing long-term in large-caps, but less applicable to active investing and shorter-term trading. This article shows you a different method of forming baselines and the win rate results for two types of stock market participants.

Traders tend to gravitate to particular strategies, largely based on how frequently the trader wants to trade.  Another point of view is that a strategy is selected, in part, because of how long it tends to hold a position.  Therefore it makes sense to evaluate a strategy by comparing it to a baseline with a similar holding time.

The baselines we use for comparison at BackTesting Report are exactly that.  They are defined by the length of time they hold a stock:

• 200 days to represent active investing
• 20 days for position trading
• 2 days for swing trading

The baselines are created with the simplest possible strategy.  We use a back-testing engine to simulate buying every stock in our test set, holding it for the prescribed period, selling and then record the profit or loss.  Of course, I wouldn’t recommend trading such a simple strategy with a real account.  It is merely a benchmark for comparison.  The figure below illustrates win rate baselines for the US stock market.

Each big blue bar on the graph represents different time periods in the stock market.  The height of the bar shows the number of simulated trades that ended in a profit.  Comparing the height of the bars, we can see differences between the test periods.  For example, on the active investing chart above where the trades went on for exactly 200 days, our simple strategy in 1994-2004 produced a 57% win rate, 2004-2007 went better with a 62% win rate, and then the party ended for 2007-2008.

We compare this to trading strategies that were back-tested on the same stocks in the same time periods.  Armed with the baseline, we can see that a strategy that wins 60% of the time in 2004-2007 is actually losing more often than average, even though it is doing better than 50/50.  In trading, win rate isn’t everything – this is just one example of applying a baseline.

The Baseline issue of BackTesting Report covers the active investing baseline in more detail and gives you the baselines for swing traders and position traders as well.  It also explains more about back-testing and how to apply the baseline.  This free pdf report is available for anonymous download.  You’ll find it in the middle of this BackTesting Report web page.

----------------------------------------------------------------------------------------------------------------------------------------------------

Jackie Ann Patterson, the editor of BackTesting Report, is an expert at evaluating technical trading strategies such as the MACD indicator and Stochastic Oscillator.  Today she shares her favorite approach to rating a strategy by comparing it to a meaningful baseline.  This article gives you a win rate baseline for active investing.  For more information and shorter-term baselines, you’re welcome to download the baseline issue of BackTesting Report free with no email address required.