What Happens the Day After S&P 500 (SPY) Is Down? Backtest of a Potential Strategy

One of the most known factors in investing is momentum. Momentum states that an asset that has been going up is more likely to keep going up in the future than to fall. It has been widely researched by academia and proven by multiple studies that it works. However, in the short term, the story might be different. We present a possible trading strategy.

The SPY tends to be higher the day after it fell and lower the day after it went up. This may seem contradictory, but we are about to show you it is true. We developed a simple trading strategy that takes advantage of this short-term pattern in the stock market and produces great returns.

In this article, we are going to look at why the SPY tends to be higher after red days, establish some trading rules, and backtest a trading strategy using Python.

Why does the SPY tend to be higher after a red day?

We can try to explain this with a straightforward concept: mean-reversion. Mean reversion is an idea in finance that suggests that asset price volatility and historical returns will eventually revert to the entire dataset’s long-run mean or average level.

For example, the P/E ratio. The average P/E ratio of the S&P 500 for the last 30 years has been around 17. However, sometimes it trades much higher than that (Dot com bubble, covid bubble) and other times much lower (Global financial crisis). Ultimately, it always returns to its mean.

Stocks don’t fall or rise in a straight line; they do so, having bounces and dips along the way. Mean reversion strategies try to capture those bounces and dips, while momentum follows the trend and ignores short-term fluctuations in price. 

So we could argue that it seems like the SPY is extremely mean reverting in the short term, whereas in the long term, you are better off following the trend. Both work well, but in different timeframes.

The day after the SPY is down – trading rules

The strategy we will backtest today may seem weird at first sight, but the idea behind it is mean reversion. The trading rules are pretty simple:

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The day after the SPY is down – backtest

We backtested the strategy in the ETF version of the S&P 500, SPY. The data is adjusted for dividends and splits. Keep in mind that up/green days and down/red days are the same thing. Here is the equity curve:

The returns after a red day are a bit astonishing! Here are some performance metrics and statistics about both strategies:

• CAGR is 7.98% for down days and 1.52% for up days (9.63% for buy and hold)
• Time spent in the market is 45.4% for down days and 54.6% for up days
• Risk-adjusted return is 17.6% for down days and 2.8% for up days
• Maximum drawdown is 30.7% for down days and 68.38% for up days (55.19%)

Not only does the red day strategy perform better, but it also spends less time in the market and has less than half the drawdown of the green day strategy. 

The day after the SPY is down – conclusion

To sum up, today, we demonstrated that the S&P 500 is highly mean reverting in the short term. The strategy we backtested today, buying after a red day and selling after a green day, confirms this statement. Nevertheless, trend following or momentum, however you prefer to call it, still works in longer timeframes.

FAQ:

What is momentum investing, and how does it relate to the SPY’s short-term behavior?

Momentum investing suggests that an asset that has been rising is likely to continue rising. However, in the short term, the SPY exhibits a mean-reverting pattern, where it tends to be higher after a red day. This short-term behavior can be attributed to mean reversion, a concept in finance indicating that asset prices revert to their long-run mean or average level.

Why does the SPY tend to be higher after a red day, and how does mean reversion play a role?

The SPY’s tendency to be higher after a red day can be explained by mean reversion. Mean reversion suggests that asset prices will eventually revert to their long-term average. Stocks experience bounces and dips along the way, and the SPY, in the short term, exhibits mean-reverting behavior. This means that after a decline, there is a tendency for the SPY to rise.

How was the mean-reverting strategy backtested, and what were the results?

The strategy was backtested using the ETF version of the S&P 500, SPY. The results showed impressive returns after a red day, with key performance metrics indicating higher CAGR, lower time spent in the market, better risk-adjusted returns, and significantly reduced maximum drawdown compared to a traditional buy-and-hold strategy.