Here is a simple mean reversion twist in SPY that holds the S&P 500 just one day (from the close to the next day’s open). It’s an overnight trading strategy, the lowest-hanging fruit in the stock market.
This article was initially published in 2013, ten years ago, and it’s about time we updated it.
The 3-day down overnight trading strategy
In plain English, the strategy reads like this:
- SPY must be down three days in a row (from close to close).
- Entry on close on the 3rd down day.
- Exit the next day open.
Here is the equity curve from 2005 until the present (the pink line is for short but uses 4 up days and then goes short):
There are 200 fills for long and a respectable 0.18% gain per fill.
Let’s backtest the strategy in Amibroker. Again, we backtest SPY, but this time from 1993 until February 2023:
There are 643 trades, and the average gain per trade is 0.13%. This might not sound much, but in a liquid asset like SPY, this is tradeable even though slippage and commissions are not included in the backtest.
The win rate is 65%, and max drawdown is 8%.
Let’s change the rules and exit on the close instead of the open:
Exiting on the close the next day is even better: the average gain increases to 0.24%! The drawback is that the win rate drops to 60%, and max drawdown increases substantially to 17%. The CAGR is almost 5% despite spending just 8% of the time in the market.
Can the strategy be further improved?
Yes, in our Monthly Trading Edge for March 2022, we made a modified version of the strategy above that returned the following equity curve (less time in the market and smaller drawdowns):
- No. of trades: 404
- Average gain per trade: 0.35% (1.35% for winners and -1.15% for losers)
- Win ratio: 60%
- Profit factor: 1.78
- CAGR: 4.6% (assuming no leverage)
- Exposure/time in the market: 5%
- Max. drawdown: -10%
In the bear market of 2022 (out of sample), the strategy made 35 trades and the average gain was 0.3%.
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