Last Updated on October 26, 2022
Pullback Trading Strategy. We have previously discussed and written why the 200-day moving average works: because you play defense if a severe recession hits. But can you combine a long-term defensive trend-following strategy using the 200-day moving average with a long-term pullback trading strategy?
In this article, we backtest a combination of a long-term trend following system and a short-term pullback strategy: a long-term pullback strategy.
The 200-day moving average
First, we recommend reading two other articles we have written about the 200-day moving average:
- The 200-day moving average: How it works, why it works, and why it doesn’t work
- A simple trend-following system/strategy on the S&P 500
The 200-day moving average works well in the stock market because it takes you out early in a major bear market. The downside is that you underperform if there is no significant bear market.
The stock market has a long-term tailwind and you can still manage decent returns with significantly less drawdowns than buy and hold if you use the 200-day moving average as a trend filter.
Enter on pullbacks in the direction of the trend
The 200-day moving average defines the long-term trend and we only want to go long if the trend is positive. But because the S&P 500 has shown strong tendencies of mean reversion since the mid-80s, we go long at short-term pullbacks if the long-term trend is positive. Thus the name pullback trading strategy.
Thus, we make the following strategy (in plain English):
- The close must be above the 200-day moving average.
- The close must be below the 20-day moving average.
- The five-day RSI must be below 45.
- If 1-3 are true, then enter at the close.
- Exit at the close when the five-day RSI ends above 65.
Alternatively, you can enter at the next day’s open with a slightly lower total return.
How has this simple strategy performed since the inception of SPY (The ETF that tracks the S&P 500)?
This is the equity chart of 100 000 compounded from 1993 until September 2021:
- CAGR is 8.3% (buy and hold 10.5%)
- Time spent in the market is only 30%
- Max drawdown is 30% (during covid-19 mess)
- Win-ratio is 82%
- Average winners are 1.9%, average losers are -2.3%
The 200-day moving average does a good job of keeping you out during long and severe recessions like in 2000-2003 and 2008/09.
Some readers might ask: what’s the point of this system when it underperforms the buy and hold strategy?
This is, of course, a very relevant question. The main “asset” of this strategy is its very low exposure time in the market which reduces the max drawdown.
Amibroker’s backtest report comes with a number called risk-adjusted returns. This is simply the return adjusted for the time spent in the markets. Our long-term pullback trading strategy has a risk-adjusted return of 27% which, of course, is pretty high.
The trading strategy performed badly during the Covid-19 mess in March 2020 and this shows perhaps that the biggest drawdown is always lurking around the corner: if you live long enough you’ll always have a big drawdown.
But overall, we believe the long-term pullback trading strategy works pretty well and most likely can be significantly improved.