Mean-Reversion within Regimes

The standard “index” for mean-reversion strategies uses the following rules:

  • Buy/Cover = Close < Yesterday’s Close
  • Sell/Short = Close > Yesterday’s Close.

I will test this simple strategy within different regimes too see how regimes influence mean-reversion strategies as a whole. I will test this on SPY from 1/1/2000 – 7/30/2012 using Yahoo! Finance data. I chose these particular dates because mean-reversion as a whole performed poorly until the year 2000 and has performed relatively strongly for the majority of the testing period.

  • First, for the test of the simple trading rules above to establish a baseline to compare the future results to.
  • CAGR: 10.46%
  • MDD: 31.32%

For some reason, ever since 2009-ish this strategy has not performed as strongly. Below is the equity chart of this system.

MR Portfolio Equity

Bull/Bear:

To classify Bull and Bear Regimes I used the RSRank Indicator described by Jeff Swanson in this post at System Trader Success.

  • Bull: RSRank > 0
  • Bear: RSRank < 0

Results:

Bull:

  • CAGR: 0.07%
  • MDD: 38.74%

Bear:

  • CAGR: 10.40%
  • MDD: 27.58%

This clearly shows that MR seems to only perform well in Bearish conditions.

High/Low Volatility:

For determining High/Low Volatility regimes I will be using the 60-day standard deviation of daily returns.  The classifications for High-Volatility and Low-Volatility with the 60-day standard deviation of daily returns

  • HV: 60-Day Standard Deviation of Daily Returns > 0.01
  • LV: 60-Day Standard Deviation of Daily Returns < 0.01

Results:

HV:

  • CAGR: 9.25%
  • MDD: 36.21%

LV:

  • CAGR: 1.11%
  • MDD: 28.08%

This shows shows that MR performs well during high volatility environments.

Trending/MR:

The TSI is an indicator created by Frank Hassler from Engineering Returns and David Varadi from CSS Analytics. The formula can be found here. The classification for Trend Vs MR with the TSI():

  • Trending: TSI()>1.6
  • MR: TSI()<1.6

Results:

Trending:

  • CAGR: -1.86%
  • MDD: 34.24%

MR:

  • CAGR: 12.56%
  • MDD: 20.88%

It’s obvious that this strategy should work well during mean-reverting regimes, and that this strategy should perform poorly during trending periods. More than anything, the results of this particular test verify that TSI is a suitable indicator for determining mean-reverting and trend-following regimes.

Conclusion:

From this we should be able to see that mean-reversion trading strategies tend to work well when the regime is classified as mean-reverting by the TSI, when the market is bearish, and when the volatility is high.

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3 comments

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