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It is common in finance to compare returns of market timing strategies to buy and hold returns. Although this is useful in determining any excess returns achieved by the timing strategy, it is far from a proof of skill. This is because, depending on the path prices follow, random traders may achieve returns much higher than buy and hold. I will approach this problem by providing two examples that are based on simulating random traders who use a fair coin to purchase shares in SPY (NYSEARCA: SPY ) at the close of a trading day and when heads show up. The shares are sold at the close of a day when tails show up and this is repeated for the whole price history under consideration. Then, the simulation is repeated 20,000 times to get a distribution of the net return of all random traders. Starting capital is $100K and commission is $0.01 per share. Equity is fully invested. Results for 2013 Click to enlarge The SPY buy and hold total return for 2013 was about 26.45%. It is shown in the results above that the return for significance at the 5% level is about 22%, which means that this return is better than the return of 95% of random traders. In this case, a return of a market timing strategy below the buy and hold but above 22% can be an indication of skill since it is significant at the 5% level or better. Also note that more than 97% of random long traders made a profit in 2013 due to the strong uptrend. Results for 2015 Click to enlarge Although the SPY buy and hold total return for 2015 was just 1.3%, the minimum significant return for comparison to random traders was about 14%! A market timing strategy would have to generate a return of more than 14% to prove that it was better than 95% of random traders, or significant at the 5% level. About half of the random long traders made a net profit in 2015, still better than casino odds of course. Therefore, even a return of 10% would not be sufficient for proving skill in this case, as it would not be significant at the 5% level. Therefore, comparing to buy and hold for proving skill may not make sense depending on the path prices follow. During strong uptrends, the minimum significant return to support skill may be closer to buy and hold but when markets consolidate it may be much higher because there are always those lucky random traders that skew the distribution of returns. As a corollary, comparing average returns to buy and hold returns may make no sense at all since the difficulty of generating excess alpha varies from year to year. Original article Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Analysis program: Price Action Lab Scalper1 News
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