For this backtest, we use the IBS indicator that measures where the asset’s close in relation to the price action that week (not day!). This has proven to be a good indicator for stocks because it’s a mean reversion indicator.
We want to find out the following: The markets sold off and closed at the lows, here is what has happened following that pattern.
The formula of IBS is like this:
(Close-Low)/(High-Low)
A low reading indicates a weak ending of the week (or day, month, or whatever time frame you are looking at), and a high reading informs us about a strong end of the week. It oscillates from 1 to 0.
The Markets Sold Off And Closed At The Lows, Here Is What Has Happened Following That Pattern
Let’s backtest the following trading rules:
- The IBS indicator ends at 0.1 or lower, and
- We sell after N weeks (1 to 5 weeks).
For S&P 500 (SPY), we get the following table:
The first column indicates how many weeks we hold. Row 5 gives us the result if we own SPY for 5 weeks after the IBS indicator ended at 0.1 or lower. The average gain over the next 5 weeks is an impressive 1.85%. As you can see, the results are positive for all weeks.
If we exit after 5 weeks the equity curve looks like this:
What about other assets?
Let’s do the same backtest for bonds (TLT):
The results are pretty good for bonds as well, but it’s a lot more erratic.
Let’s do the same backtest for gold (GLD):
Even for gold, the results are positive. However. It’s quite erratic and not tradable, in our opinion.
