In this article, I will reverse the trading rules on a long-only trading system and see if we can build a profitable shorting trading system. Let's do this and see if any edge awaits us.
As pointed out in a previous article, "Profit By Combing RSI and VIX", combining RSI and VIX can be a profitable strategy for trading the S&P. If you're not familiar with this simple yet powerful strategy, please take a look at the previous article first.
Shortly after the original article was posted, a reader asked what this strategy would look like if we reversed the rules and took short positions.
It's an exciting idea and something I've not tested in many years. Here's why...
First of all, I'm not a big fan of long/short symmetry with trading systems, and the difference between market psychology between bull and bear market participants can be huge. Thus, simply reversing long-only rules to trade the short side is often ineffective. This may not always be true, but it has been my general observation.
Furthermore, based on past testing, I recall that many Connor's RSI strategies don't do so well trading the short side. However, it's still a great idea to test.
The Original Rules (Long Only)
As a reminder here are the original rules for taking long trades:
- Price must be above its 200-day moving average
- RSI(2) on price must be below 30
- Buy when RSI(2) of the VIX is above 90
- Exit when RSI(2) of the price rises above 65
Note I will be trading the E-mini S&P. Unless otherwise stated, all the tests performed in this article will be based on the following assumptions:
- Starting account size of $100,000.
- Dates tested are from 2000 through May 30, 2022.
- There are no deductions for commissions and slippage.
- There are no stops.
Below is the equity curve of the original trading rules as provided above.
The results are promising but not great mainly due to the significant drawdown. Of course, this strategy has no stops, so adding a hard stop can mitigate that. The important thing to note is that the equity curve rises from left to right and continues to make new equity highs into 2022.
Now, let's take the trading rules and invert them. We'll attempt to take short trades during a bear market.
Inverted Rules (Short Only)
Here are the new rules, inverted for taking short trades:
- Price must be below its 200-day moving average
- RSI(2) on price must be above 70
- Sell short when RSI(2) of the VIX is below 10
- Exit when RSI(2) of the price falls below 35
Below is the equity curve for trading the E-mini S&P based upon the rules as defined above.
We have a different story here. First, the equity curve peeks around trade 155, about 2008. Thus since 2008, the equity curve has fallen. That 14 years of no profit!
It does look like this shorting strategy held an edge until 2008, but since then, not so much. We all know shorting strategies on the stock index markets can be challenging to create.
One example of a successful shorting system for the US index market can be found in another article here.
Getting back with our shorting strategy, let's test something a little different. Going long during a bear market!
Going Long In A Bear Market
What would happen if we simply go long during a bear market? The original rules called for trades only when the daily price is above the 200-day moving average. Let's turn that around and go long only when price is below the 200-day moving average. Below is the equity curve.
This looks better than I thought it would. Even going long during a bear market produces a positive return. However, lots of drawdown!
This gets me thinking. Bear markets are a lot different than bull markets. Connor's originally developed his trading rules for bull markets so let's change the parameters.
Going Long In A Bear Market (Modified Parameters)
I optimized the VIX Threshold and the Price Threshold. I wanted to see how many combinations are profitable. It turned out all are profitable which is a good sign. Below is a graph of the 108 combinations I tested. All positive!
I then picked a pair of parameters that did not appear to be outliers. Those values were:
VIX Threshold 50 instead of 90. This means the amount of fear does not have to be as extreme to trigger a trade. This will produce more trading opportunities.
Price Threshold 20 instead of 30. This requires price to experience a deeper pullback.
Both of these change makes sense. We want a deeper pullback and price so we require the RSI threshold to be lower. We also want to generate enough trades so we lose the restriction on the VIX Threshold. Below are the results:
It’s clear that simply reversing the rules do not produce viable results. However, going long during a bear market creates better results than one might first imagine. Here is a couple of ideas for you to test:
1. Try adding a stop to this strategy. Remember, as the strategy currently stands it does not have a hard stop. So, attempt to reduce drawdown with a stop. This will most likely come at the expense of sacrificing some returns. That's OK.
2. Combine this strategy with the original rules, "Profit By Combing RSI and VIX. " You then have two independent trading systems. One trading during a bull market and one trading during a bear market. This would be an exciting combination!
Let me know how your testing goes. Leave a comment below!