Rule # 4: Define the Current Regime

Trading Rules Series

Hi, everyone! Expanding on our Trading Rules Series with the current market turmoil would be fitting. I believe it was Steve Cohen who stated that individual equities returns can be broken down into three parts:

1. 65% of returns are from the market factors

2. 25% of returns are from the sector factors

3. 10% of returns are from the individual equity factors

That means 90% of an equities performance is from macro/higher level forces regardless of the individual equities fundamental story. A rising tide lifts all boats. If this is the case, we want to align our trading to allow the market to do the heavy lifting for us. This applies to short-term trading as well. As traders, we strive to trade in market conditions that maximize our edge. This is the purpose of regime modeling.

There are many ways to define a regime, but the three main components are:

1. Trend/Momentum

2. Volatility

3. Fundamentals

Ideally, all three factors should work in your favor, but a single regime filter may suffice. Regime modeling can be as simple as a Moving Average and ATR% or as complex as machine learning and Markov models.

In this chart of Gold, you can see different long-term trends and volatility cycles:

With this information, we can create a four-state regime matrix:

1. Trends

   1. Bull

   2. Bear

2. Volatility

   1. High

   2. Low

To identify trading advantages based on different market conditions, you can sort trades based on asset regimes. This means only executing trades when they align with the current regime state, which requires discipline and patience to wait for favorable conditions before trading. It may be tempting to constantly trade or hold a position, but this can result in higher portfolio turnover and lower returns. By using a regime filter, trading becomes a more targeted and assertive strategy rather than a haphazard approach.