The True Edge of the DLA
By
Leo Valencia
With the close today the DLA is batting 3 trade jackpots in a row (max gain trades) with gain per trade north of 700%. With those numbers is easy to get lost in the hype and the adrenaline and forget that even though the DLA has been very accurate over the whole of 2017 and start of 2018 (64% precision), the true edge of those trades doesn't come from the DLA signals themselves. Instead the edge comes from an structural mispricing of binary calls in SPX.
The mispricing is very simple to figure out. Just compute the number of Expected weekly log returns in SPX of 1% up or more and you will notice that since 2009 they have been around of 30% of the time (In 2017 we got 29% of those moves). So you would expect the 1% up weekly binary calls to be priced at 30% (fair price), however it turns out that those binary calls come in substantially cheaper ranging from 11% to 20% so there is gigantic edge right there.
As I have shown before even a Naive strategy of blinding buying 1% up weekly calls all the time would have delivered positive expectancy during 2017. In fact the edge is about $74 for every $100 risked (positive). So please appreciate this true source of edge, for some interesting reason (structural is my guess) the binary calls remain underpriced and even without the DLA we could have been exploiting this aberration for profit.
With that being said, the beauty of the DLA is that it enhances the naive strategy to the point of delivering $270 of edge for each $100 risked (mind numbling). However no amount of neural network magic would be able to deliver those impressive returns if it were not for the implicit edge already present in the trade.
So remember that although DLA seems to be the star "du jour" there is no such thing as the holy grail and trading conditions change all the time. So far we should be really happy with the current performance but we need to be ever vigilant to evolving market conditions. In particular we need to make sure that the structural edge remains present. The day that the weekly 1% up binary call starts to be priced higher than 30% then it will be over for the DLA. So let's cross fingers that such a situation doesn't happen in 2018.
