[I wrote a draft of this piece the other night and with well timed irony, the S&P 500 has finally pulled back]
One thing that's puzzled me is what to do with trend following markets. There has been a lot of research on what to do with a mean reverting market using short term indicators such as the DVB or RSI (2) (2 period RSI) - I.e. buy over sold and sell over bought readings etc.
But what about markets which are not as prone to mean reversion? Should you just reverse the rules and buy on strong readings etc? Another options its to employ a relative strength rotation model which holds the best trending markets as with the Livermore Active Issues.
Many people have also be commenting on the recent rally on the S&P 500 and other markets. I can't remember the exact stats, but Bespoke pointed out that it had been some time since there was a 1% correction.
Anyone trading the basic short term mean reversion rules for indicators such as the RS2 or DVB will have had their patience tested in recent weeks as the market continued to push higher. The screen grab below shows the S&P 500 with the DVB indicator below it. The basic trade idea is to buy when the DVB drops below 50 and sell when it moves above 50. As you can see, the DVB has been above 50 for some time.
I tested the 20 period average of the DVB on the S&P 500.
Interestingly, your average return per trade is increased by trading in line with the 20 period average of the DVB. For example, if the DVB is below 0.5 and the average DVB is above 0.5, no trade.
It's not a spectacular addition, but maybe worth some further investigation. Looking into the standard deviation of the DVB or RS2 also seems to be useful from my quick study. Essentially the returns from trading a short mean reversion strategy are lower when the standard deviation of the short term indicator is below average. This kinda makes sense as if you look at the chart above, you can see the DVB barely moving for weeks, which is what you get during a steady uptrend (bad for mean reversion).
Trend following markets
This got me thinking about trend following markets and the best approach to take. If a market is more prone to trend following then trading short term mean reversion will be ineffective and trading the opposite rules may actually work out better.
Foreign exchange (Forex) is certainly more prone to trend following and in my experience short term indicators such as RS2 don't work when applied in the usual way. They actually make a small profit when traded with the opposite rules (Buy on high readings etc).
I wondered what would happen if you applied the 20 period average of the DVB to EUR/ USD (Euro to US dollar spot rate). The red line is the 20 period moving average of the DVB.
Buy the EUR/ USD when the 20 period average of the DVB is above 0.5
Sell(short) the EUR/ USD when the 20 period average of the DVB is below 0.5.
No commission spread etc. EUR/ USD spot since 1998.
The average margin per trade is small, with the average trade making 0.03% profit with a 51% strike rate. Too small in its own right to be a devastating strategy. However, it does lay out a good platform on what is usually a very tricky market to trade and I've found a few interesting angles already by delving deeper. I'll have to keep those under my hat for the moment though.
- There is a massive difference in the reaction of the euro ETF (FXE) and the EURUSD spot rate in how they respond to mean reversion strategies despite being highly correlated, they appear to be two different beasts and this difference mainly came about in the last 12 months.
- I have only quickly tested the RSI2 average and it appeared to make similar ish results, though not as good.
- Standard deviation of the DVB/ RSI2 etc could be fruitful area to look at.
- Correlation between the EUR/ USD and the SPX has also yielded some interesting results for the average DVB idea. As the SPX has responded well DVB type strategies in the last few years (though as MarketSci point out, simple buy on down day type stuff has gone off the boil), this will also impact on currencies when they are correlated highly with stocks.
- The dollar index actually performed the best in my testing compared to the eur/ usd, indicating that it is the dollar itself on a trade weighted average which is the core trend following element of the eurusd (though the euro contributes a big slug of this trade weight).
Appreciate any thoughts...
[Post Script] David Varadi's De trended indicator concept looks to be an elegant way to deal with trending markets. I just haven't had chance to analyse it yet.