TimingCube - Drawdowns and risk management - cash signal,trailing stop,risk management,market rebounds,mild pull-backs

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Make sure you do not miss this week's Trend Timing School editorial and the introduction of our trailing stop Cash signal!

Signal Update

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500
		QQQ

Cumulative Returns since First TimingCube Live Signal () as of

Index	Long Only	Long Only with Margin	Long & Short	Long & Short with Margin	Buy & Hold
Nasdaq 100
Russell 2000
S&P 500
QQQ

Note: QQQ returns are included for continuity sake.

Market Update

This week, markets faced their most significant challenge since our current Buy signal was issued on April 2, 2003. All major indices plunged for four days in a row, with the selling culminating on Thursday afternoon after it was announced that Al-Qaida may be responsible for the Madrid terrorist attacks. Markets behaved much better on Friday, recapturing some of the lost ground of the previous two days, as investors took advantage of oversold conditions to drive prices back up. For the week, the Nasdaq 100 lost 2.82%, while the S&P 500 shed 3.14%. Once more, the Russell 2000 outperformed by losing only 1.63%.

To finish, let's put things in perspective: compared to the huge gains achieved since the market bottomed out in October 2002, recent losses have been pretty small. As of today, the Nasdaq 100, the Russell 2000 and the S&P 500 have only retreated 7.87%, 3.10% and 3.21% from their respective 52-week closing highs. This means that none of the indices we follow has even entered formal correction territory, which is defined as a 10% drop from the high (see today's Trend Timing School editorial below). Despite this week's losses, our current Buy signal therefore remains active.

Trend Timing School

Drawdowns and risk management

The Trend Timing philosophy is anchored on the very notion of risk management, by participating - being long - in all substantial up moves during major rising trends, and by benefiting - being short - from all substantial declines, instead of suffering from the drops with Buy and Hold. We also strongly resist tinkering with the Model, unless there is evidence of compelling benefits.
Today, we have one such rare change, and we are pleased to announce that we are adding a 15% trailing stop Cash signal to our risk management arsenal. If the stop is triggered, our Model will automatically issue a Cash Signal and you will be notified.

Since our Model does not call or predict tops and bottoms (because no one reliably can), but rather identifies the major trend shifts as they happen, a proper balance must be kept between infrequent trading, 3 to 5 per year on average, and keeping the downside limited. By and large our Model has kept us correctly on course through the many pull-backs and small corrections, and has switched us to Sell during more severe corrections and bear markets. An upcoming Trend Timing School article will expand on this subject, but for today, suffice it to say that a widely accepted guideline for pull-backs is 0-10% from the recent top, corrections are between 10 and 20%, and bear markets anything over 20%. So, the age old question is "how much do I give back before the next signal comes?".
This introduces the notion of "drawdown" which is the percentage decline from the most recent top before a Sell signal is issued. Conversely, during a Sell signal it is the amount of increase from the most recent low before a Buy signal forces us to cover our shorts. For simplicity, we will stick with Buy signal examples, knowing that during a Sell everything is the same, except upside down.

The good news is that over our entire backtested and live history (since 1989) the highest drawdown during a Buy signal has been 15%, and 19% during a Sell. The bad news is that nothing says that the next could not be bigger. We have long recognized that not having a hard limit for the maximum drawdown is not only unsettling to most of us, but ultimately represents a gap in our risk management defenses. The tricky part is that most trailing stops are too tight and they increase the number of trades substantially, and more often than not, switch you out for a mild pull-back and leave you stranded while the market rebounds.

Additional research we completed recently clearly points to the value of a formal trailing stop Cash signal, and to the optimum limit being set at 15% (which corresponds to the size of an average correction). How this would have worked with our Model since 1989 can be seen in detail in the "Nasdaq 100 Historical Performance with Trailing Stops" table.
The conclusion of this study is that it would have only slightly reduced our overall returns and added only a few signals, therefore maintaining our 3 to 5 signals average per year. A small price to pay for added security and peace of mind.

Here are the specifics about the new trailing stop Cash signal:

The new rule is added to our Model effective today, March 12, 2004
As for most Model components, the Nasdaq Composite Index closing price is our benchmark
If the Nasdaq Composite reverses by 15% from its most recent closing high while a Buy signal is active, or from its recent closing low while a Sell signal is active, a Cash signal is issued (unless the long standing 9% from entry point Cash signal rule is triggered first)
With a Cash signal, we liquidate all our positions and keep the proceeds in cash or Money Market funds
If, after having been stopped out by a Cash signal, the market continues to deteriorate a Buy/Sell signal would ensue. If, however, the market recovers to -10% or better, the signal that prevailed before we got stopped out resumes
You always know at which Nasdaq Composite level a Cash signal will be issued: 9% from entry point, or 15% from an intermediate bottom or top. Depending on the investment vehicle and strategy used your actual losses could be higher or lower and there is no hard limit on how much stock investments could fall in a single trading day

From entry point on a new signal, the 9% Cash signal is still in effect, as we never want a real loss of more than 9% of our money (18% with margin).

However, once your investment has grown by 7% or more, it makes sense to ratchet-up the stop to 15% so that the decline required to trigger a Cash signal remains at 9%, as with our original Cash signal. Once our current position has gained 15% or more, we are only giving back paper gains, not losing real money as on entry.

Yes, there can be circumstances when the trailing stop is not the best path, in the earlier example of the 19% drawdown, the market then rebounded, which means that having been stopped out at -15% we would have only rejoined the Sell when it recovered to -10% or better. This would represent a 5% disadvantage compared to not cashing out. Or maybe the investment vehicle you use, such as QQQ, moves a little faster than the reference Nasdaq Composite. It is our feeling that most people would still chose the safety of always knowing what the maximum downside is.

Another advantage for subscribers using margin is to know that you will never get a margin call. Before you would get a margin call your security would have to lose 30% of its value, which can no longer happen with the 15% trailing stop.

In summary, we can now hope that the bull market resumes its upward progress with the peace of mind of knowing that our downside risk is limited and known.

FAQ of the Week