In a recent post, friend of the blog vimal wrote this:

I like the indicators you use here. I have one query. How would you have utilised this in July and august 2011 as the market decline then was waterfall like. Buying for a potential bounce was tricky for me personally.

There is a simple answer to this question. Sometimes one buys the waterfall, but most of the time one buys a normal dip. In other words, if the dip-buying strategy is sound, more will be won than lost, even when suffering through the occasional waterfall. Using filters in an attempt to eliminate buying waterfalls can sometimes reduce drawdowns but come with the expense of reduced profits. That point needs to be over-emphasized: Filters don’t always reduce drawdowns but they almost always reduce profits.

Let’s take a look at filtering in practice. We’ll apply a filter to the simple breadth system which elicited Vimal’s comment. While the system is triggered by extreme breadth readings, the essence of the system is that it buys SPY dips.

To be continued…