The Trend Is Not Your Friend In SPY/S&P 500 (and other stock indices)
Last Updated on June 19, 2022
I guess most traders have heard that “the trend is your friend“. Personally, I don’t do trend-following strategies, I go the opposite way: buy weakness and sell strength – mean reversion strategies. However, this depends on the instrument you trade and of course on the time frame in trading.
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 the best strategy, mean reversion or trend following. For me, this is a pointless discussion: There is nothing as best or worse: one has 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 these results on a basket of ETFs: buy when RSI(2) drops below 10 and exit after two days. Both entry and exit are 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 the 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 the 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 too many traders looking at the same thing? The markets always change, especially when there are clear patterns. Everyone trades them and they disappear.
“The trend is your friend, if it is not about to end”. With the development of almost 24h trading markets have become much more choppy and fragile. We all have to rethink strategies going forward. The only “market” where “trends”, at least except very long trends, still might work would be analyzing the pairs between different sectors/indices etc, they have yet to become that choppy but more “trendy”.