Evaluating Different Market Timing Strategies

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Evaluating Different Market Timing Strategies

Many academics will tell you that the markets are random and efficient. And as a result, there is no point in trying to predict the price of any financial security. On the other hand, there is an opposing view that holds that price movements can be predicted with the right timing tools and models. This latter group are proponents of market timing, which will be the focus of this article.

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Understanding Market Timing

Market timing is a strategic approach to the markets wherein an investor or trader seeks to buy or sell a financial instrument based on future anticipated price movements. These participants that use market timing models believe that the markets have some level of predictability in terms of expected price changes.

This is contrary to the efficient market hypothesis, also known as EMH, which suggests that the future price movements in the financial markets cannot be predicted with any level of accuracy, and as such, any  and all stock, commodity, and forex market timing models generally fail to realize any distinct edge. Proponents of the EMH theory believe that the best course of action for market participants is to buy-and-hold a broad market index or ETF, which would provide exposure to the overall market as a whole.

For our discussion here, we will focus on better understanding market timing and the pros and cons of implementing an actively managed strategy. Market timing can come in many different forms and can be implemented in a wide array of financial trading instruments. Regardless, the general concept behind market timing remains the same. That is to say that market timing models will seek to predict future price movements, and those implementing market timing models firmly believe that the markets present opportunities wherein they can gain an edge to profit from certain inefficiencies or price behavior.

Although there are a group of traders that tend to use market timing for longer-term price predictions, such as trend following traders in particular, the overwhelming majority of traders that focus on timing the market are involved in intermediate term swing trading, or shorter-term day trading time horizons. One of the reasons for this is that over the longer term, macro-economic and fundamental events tend to drive the market, while in the shorter-term there is more price inefficiencies that can be exploited.

It should be made clear from the outset that timing the market can be difficult to do consistently, and even the best market timers will have periods of drawdowns where their strategy or system becomes out of tune with current market conditions. As such, market timers need to be ever cognizant of the market environment and adjust their strategies to align with such conditions. This is particularly true of intraday market timing as sentiment can quickly change due to news events.

An important concept that traders need to understand when building a market timing model is the concept of liquidity. Liquidity is the ease at which a trader is able to execute buy and sell orders with minimal slippage costs. In other words, you want to be focusing on instruments where there is a good amount of volume and depth in the market. This will allow you to execute trades in an efficient manner with minimal trading costs.

Moreover, you need to carefully evaluate your trade size to ensure that your position sizes can get executed with minimal friction. For example, if you are an equities futures trader trading on a 50 contract basis, you can easily get in and out of the E-mini S&P 500 market, however, you may have a more difficult time executing at your preferred price if you were trading on a 50 contract basis within the much less liquid orange juice futures market.

Pros Of Market Timing

Now that we have a better understanding of what market timing is, let’s move on to discuss some of the major advantages of using a market timing technique.

Higher Profit Potential – One of the primary draws of building a market timing model is that it can provide for increased profit potential. Traders that are able to find an edge within a particular strategy or system can increase their trade frequency and extract more profits from the market. So, if the trader does have a discernible edge, they can routinely play that edge in the market over and over again for profit.

It’s important to note that certain edges that exist in the price series at one time or another, may disappear at some point in the future. As such, it is the job of a market timer to continuously research different market edges so that they are not reliant on any one specific market timing strategy that may lose favor over time.

Well Suited For Short-Term Traders - Market timing is particularly well suited for short-term traders such as day traders and swing traders. Often, you will find short-term arbitrage opportunities on the price chart. Traders that are astute enough to recognize these inefficiencies can profit handsomely from these scenarios.

There are day trading market timing strategies and swing trading market timing strategies that are based on candlestick patterns, classical chart patterns, harmonic patterns, and many other technical based methods. And these patterns appear across all time frequencies, but they tend to more reliable on relatively higher time frame charts such as the one hour, two hour, and four our time frames.

More Control Over Your Portfolio - Market timers tend to have more control over their portfolio selection. Unlike many of the standard market capitalization ETFs that are bundled using the market cap of each constituent stock within a specific index, equity traders that trade using a market timing approach can choose to trade only those stocks that show the most promise.

Additionally, a market timing system would allow you to enter and exit the stocks within your portfolio at different times based on your particular strategy or model. Overall, a market timing approach allows for more flexibility and control over more conventional buy-and-hold investing strategies.

Can Help Reduce Risk - Without a doubt, the key ingredient to success for any trader is their ability to minimize and contain risk at all times. Although we can never know with full certainty what the future holds, we can control the amount of exposure we have in the market. Successful market timers have learned that they can be nimble in the market and minimize risk at the same time.

Unlike most buy-and-hold trading methodologies where stop losses are rarely used, a market timing model generally incorporates some form of initial stop loss and trailing stop loss mechanisms. This helps a trader or investor to reduce risk while gaining the benefits of price momentum within the chosen instrument.

Ability To Go Long And Short - Last but not least, those that practice a market timing approach, will generally trade both sides of the market without any bias for one side or the other. This can be a great advantage over the overwhelming number of long only strategies that are the staple of most buy-and-hold approaches.

Because market timers will often go short just as much as they go long the market, they can quickly adapt to changing market conditions and take advantage and profit from bear markets in the same way as they can from bull markets. This is particularly true for traders that specialize in the futures market or the Forex market. Within the context of these markets, going short the market requires no special rule, such as the uptick rule in equities. Therefore, bearish positions can be expressed much more seamlessly within these financial markets.

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Cons Of Market Timing

Now that we’ve discussed some of the benefits of utilizing a market timing methodology, let’s now look at some of the drawbacks. Below you will find some of the more obvious challenges with incorporating a market timing style of trading.

Requires More Time To Manage - One of the great things of a buy-and-hold strategy is that it requires very little time to manage. Once you have selected the stocks to include within your portfolio, you can sit back and relax, and let the market take care of the rest. If all goes as planned, you should earn a decent rate of return from your buy-and-hold portfolio over time.

Traders that include market timing as their primary mode of investing require a much more active role in the decision processes around their portfolio. This could include tasks such as stock selection, research and development time, trade management techniques, position sizing parameters, and more.

Increased Trading Costs – Due to the inherent nature of shorter-term market timing models, they will incur higher trading costs compared to more passive buy-and-hold market approaches. These increased trading costs can come in the form of direct and indirect costs. Direct costs would include things such as commissions and bid ask spreads. Indirect costs would generally come in the form of execution inefficiencies and slippage.

As a result of this, shorter-term market timers need to devote some time to back testing their strategies with these real expenses added into their overall cost component. Sometimes traders will find that their market timing system that performs relatively well without these related expenses, may turn out to be a breakeven or even slightly losing system afterwards.

Higher Tax Implications - Most traders and investors spend very little time trying to understand the tax implications of their trading method. It’s not until a trader does his or her taxes at the end of the year, that they come to realize the outsized tax burden that comes with short-term trading. For example, within the United States, the tax code breaks up capital gains into two primary categories. The first is long-term capital gains, which is usually taxed at a rate of 15 to 20%. In order to enjoy this reduced tax rate, an investor must hold a position for a minimum of one year.

The second is the shorter-term capital gains rate, which is taxed at the ordinary income tax rate, and applies to those positions that are held for less than one year. And for most investors and traders, the ordinary income tax rate would generally be much higher than the longer-term capital gain tax rate. The above generally applies to equities and equity options traders.

Difficulty In Finding A Consistent Edge - One of the most difficult aspects of market timing is actually finding a market edge that you can apply in the markets consistently over time. In other words, you may find a particular strategy that you have back tested and which appears to work well over the historical data, but after trading it in a live market environment, you may find that the performance results diverge greatly from your expected results.

This is a common problem and one that should not be understated. In other words, finding a real edge in the market is very difficult, and if and when you do find that edge, it may not persist into the future or you may have inadvertently curve fit the data to work in theory but not in practice.

Stock Market Timing Strategy

Let’s now try to build a simple market timing system for the stock market. The strategy that we will describe is based on the Relative Strength Index indicator, which is a popular momentum based oscillator. Many traders are familiar with the RSI indicator, which comes with the default settings of 14 period.

But this strategy uses a 2 period RSI for generating signals. This mean reversion trading strategy was popularized by Larry Connors and seeks to find short-term imbalances in the market. The strategy is best incorporated on highly liquid stocks or ETFs.

So here are the rules for entering a long trade using the RSI(2) Stock and ETF market timing strategy.

• 2-period RSI must register a reading of 10 or below. This suggests that the market is extremely oversold, and due for a rebound to the upside.


• The price must be trading above its 200 day simple moving average.


• Enter a buy order at the open at the beginning of the next session.


• Exit the long position upon a cross above the five day simple moving average.


• A stoploss is not used within the strategy, as it tends to degrade the performance results.

And here are the rules for entering a short trade using RSI(2) strategy

• 2-period RSI must register a reading of 95 or above. This suggests that the market is extremely overbought, and due for a correction to the downside.


• The price must be trading below its 200 day simple moving average.


• Enter a sell order at the open at the beginning of the next session.


• Exit the long position upon a cross below the five day simple moving average.


• Again, A stoploss is not used within the strategy.

RSI (2) Market Timing Trade Example

Let’s now take a look at the RSI market timing trading system on a price chart. Below you’ll find the daily price chart for Apple stock. The price action chart displays two moving averages. The blue line represents the 5 day simple moving average, while the orange line represents the 200 day simple moving average. The RSI(2) indicator is shown on the lower pane below the price action.

We can see that the price was trading sideways for some time, and the market volatility was quite subdued. Towards the center of the price chart, we can see a major gap up which closed down for the day. Following this event, the price began to move lower quite precipitously and soon entered into oversold territory based on the RSI(2) indicator. We can see that the RSI(2) reached a level below the 10 threshold as shown by the orange circled area near the bottom center of the chart.

This occurrence would have acted as our buy market entry timing signal point. However, before entering into a long trade here, we would have needed to confirm that the price was trading above the 200 period simple moving average line. As we can clearly see, the price was indeed trading above the orange 200 SMA line when the RSI registered an oversold reading.

As such, this would have confirmed our trade signal, and we would’ve entered into a long trade at the open on the following trading session. From there, we would’ve waited until the price moved above the 5 period SMA to exit the trade. You can see that on the second day following the buy entry signal, the price crossed above and closed above the 5 day SMA line.

The RSI(2) strategy is a simple market timing trading system, but one that is quite powerful. It has been shown to perform well in many stocks, but, tends to work best on highly liquid ETF instruments.

Download the short printable PDF version summarizing the key points of this lesson…. Click Here To Download

Summary

Market timing is a technique for initiating investment and trading related decisions based on the idea that price movements can be predicted into the future. There are a wide array of different market timing models that traders can use to express their opinion about the future price of an instrument. Some of the most popular among these are based on technical analysis.

We described one such market timing model in this article. More specifically, the RSI(2) market timing system is used to find pockets of opportunity within the stock market. Although this strategy can work across many different trading instruments, it is particularly well suited for stocks and ETFs.

Although the idea of timing the market is foreign to many novice investors, those that take the time to study the charts will soon learn that the markets do display some common tendencies within the price action. This commonality, although never exactly the same, can provide great insights into future price movements, as any serious market timer will tell you.

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