The Trend Is Not Your Friend In SPY/S&P 500 (and other stock indices)

Freeimages.co.uk

I guess most traders have heard about that “the trend is your friend”. Personally I close to never trade on trends, I go the opposite way: buy weakness and sell strength. However, this depends on the instrument you trade and of course on the time frame. In general most currencies and commodities show a tendency to trend more than stocks and/or stock indices (at least according to my research). On the internet you can find a lot about discussions which is best strategy, mean reversion or trend following. For me this is a pointless discussion: There is no thing as best or worse: one have to do research and trade the result if it makes sense, be it mean reversion or trend.

I trade SPY/ES. I’m in the process of looking at some new strategies, but first I would like to check which time frame it’s best to look at (for mean reversion). So I checked how much mean reversion there is in this instrument. To do this I simply used a scatter plot to show the return for one period against the other. Comparing different time frames it seems like 2 days show the greatest mean reversion. Here is the scatter plot from 2005 up until July 2012:

The correlation is -0.12. As you can see from the plot there is an inverse relationship: if a 2 day period is positive, most likely the next 2 days will show opposite returns.

I have also tested this on some other markets:

EWA: Australia -0.07

RSX: Russia -0.08

EWZ: Brazil -0.11

I tested this results on a basket of ETFs: buy when RSI(2) drops below 10 and exit after two days. Both entry and exit is on the close:

 

As you can see the result is pretty good for such a simple strategy. However, what this does not show, is that the strategy shows weakness after second half of 2010. 2011 would have been a loss as a portfolio, but 2012 holds up pretty well.

Doing the opposite, going short, shows a similar bar chart but with about half average return per fill.

However, the mean reversion has somewhat abated over the last couple of years. Why? I have no idea. Perhaps it’s to many traders looking at the same thing? The markets always change, especially when there is clear patterns. The everyone trades them and they disappear.