Daily Follow Through, Mean Reversion, and a Secret Ingredient: Part 3

In the first post, I established that a very basic method for determining whether a market was following-through or mean reverting was to track daily follow through. The second post looked at the results of a simple daily follow-through strategy.

Now we want to look at the performance of a daily mean-reversion strategy. It is important to know which method is working as it tells us whether it is better to follow the market or trade against it. Finally, a basic quantification will be identified (the secret ingredient) which we will use to determine when to switch between trading daily follow-through vs. daily mean-reversion.

Daily Mean-Reversion- All SPY History

Daily Mean Reversion strategy:

Buy Signal: If the today’s close is lower than yesterday’s close, then buy the close.

Sell Signal: If today’s close is higher than yesterday’s close, then sell short the close.

This strategy will stay long (or short) as long as the closes continue to be lower (or higher) than the previous closes.

No commissions or slippage was used in the testing.

Results:

Some of the key metrics to note are the Net Profit %, Annual Return, Avg. Profit/Loss %, Avg. Bars Held, and Percentage of Winners. You might also want to notice the differences between the long and short trades.

Pay particular notice to the Percentage of Winners: 64.17%. The daily follow-through strategy’s win percentage was 34.05%.

Another metric to note is that the max trade drawdown for the daily mean-reversion strategy is twice as large at -20.88% than for the daily follow-through strategy. Trading mean-reversion can provide superior returns, but it requires better risk management and position-sizing (in my humble opinion) than trading with the trend.

They say a picture is worth a thousand statistics, so now lets see the equity curve.

Daily Mean-Reversion Strategy Equity Curve:

The equity curve clearly shows when daily follow-through quit working…and consequently, when daily mean-reversion became the play du jour. As a side note, the equity curve is even nicer if we eliminate the short trades, but that is another conversation for another post.

The simplest interpretation of this equity curve is that it has not worked to trade in the same direction as the market, since 2001. The last decade has truly been the contrarian’s market.

And, in the large jump in equity beginning around the end of 2007, there is a clue provided as to what is the secret ingredient.

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In Part 4, I’ll introduce the secret ingredient. The fun part is when we attempt to combine both strategies, using the secret ingredient to tell us when to switch between one or the other.

Feel free to leave a comment or ask a question, especially if I have been unclear about anything up to this point.