Trading the US Dollar with the S&P 500
By Michael Stokes | August 25, 2008 | 10:08 AM | 0 Comments
This post is about two things: (1) a trading strategy to go with our recent research into the connection between the US dollar and stocks, and (2) a very clear example of why adaptive trading strategies are so powerful.
Previously I showed that the US dollar (USDX) strongly influences same-day returns on the S&P 500, but this post is about future returns, and for future returns, the relationship is flipped - the S&P 500 strongly influences the USDX.
The graph above shows the USDX (blue) and the following strategy (green) for trading the USDX from 1995 to 2003: go long the USDX at today's close when the S&P 500 closes below its 2-day simple moving average (SMA) today and short at today's close if it closes above. This is a proof-of-concept, so I'm assuming frictionless trading (no transaction costs, tracking error with the index, etc.)
That's a very consistent result: annual returns of 16.8% (vs -0.3% for the index) and a peak drawdown of -9.5% (vs -28.4%). But look at what happened after 2003:
The entire relationship turned on its head. The worse part is that this change was NOT related to the decline in the dollar - the decline began long before the strategy stopped working. This was a fundamental shift in the dollar/stock relationship.
Now, a trader could just flip the rules of the previous strategy, and I think that would be okay, but this post raises a larger question: what are traders to do if they are constantly threatened by fundamental changes in everything they know to be true? One solution is an adaptive strategy.
A Case for Adaptive Systems
An adaptive system (like our YK Strategy) isn't programmed with static rules like a traditional strategy; rather, it's designed to "learn" from the markets. In theory, as market fundamentals change, the strategy should change with it.
Just for giggles I took this strategy and put it into our YK model. I told it to only use the 2-day SMA discussed above to make its decisions and nothing else. The result...
The blue line is the original strategy result and the red line the adaptive strategy result. Note how the adaptive strategy stumbled a bit as fundamentals shifted, but eventually it adapted and continued its upward march...a clear example of an adaptive system trumping a static one.
Happy Trading,
ms
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