Thursday, August 21, 2008

How To Trade The Choppiest Environment In 50 Years

If you trade trend or breakout strategies and have found the market difficult in the last year or so, I’m about to show a prime reason for that diffuclty. Below is a strategy that buys the S&P 500 on the close of any up day. The position is closed at the close of a down day. Essentially your looking to buy strength and sit out weakness.

This strategy worked well in the 90’s, but since the market topped in 2000, it has performed poorly. Since the Spring of 2007 it has really accelerated lower. What this means is that performance following up days has been especially bad. It suggests the environenment has been especially choppy. Whereas strength begat strength in the 90’s, it has led to immediate weakness since.

Now let’s take a look at downside follow through. In this case the strategy is to sell short on any down day and then cover on an up day.

This was a break-even strategy through July of 2002. Since then it has done terrible. Interestingly, it’s done especially bad over the last year plus. Even though the market has fallen precipitously, the manner in which it has occurred has made it difficult to profit if you’re trying to short breakdowns. Down days have been followed by up days.

What about a combination strategy? Buy strength and short weakness in anticipation of further follow through. Below is a chart with the combo strategy:

Again, since March 2007 this strategy would have experienced an incredible freefall.

Perhaps it would be best to take a step back, though. In the next chart I show back to 1960 instead of 1993 in an effort to find other periods where choppiness has been so prevalent.

As you can see, buying after strong days and selling after weak ones worked well for 40 years. In 2000 that changed, and the last year and a half is the worst it has ever been with regards to follow through. This would suggest that strategies that may have worked well for forty years or more could be suffering greatly now. Traders should consider the current choppy market behavior when designing strategies. Buying weakness and selling strength is working better than buying strength and selling weakness. They could also monitor charts like these to see if tendencies begin to revert back to pre-2000. If tendencies do revert, adjustments may be needed.
Update: I just saw that Dr. Brett Steenbarger also addressed this topic in his blog today. He looked at it from an international standpoint as well. Click here to see his findings.


itrade4real said...

Great study topic! When I started training at a prop firm years ago, the first "system" they taught us was exactly as you describe above, and was called "overnighting". We simply bought all the strongest stocks (in an up market) before the close, hoping to capitalize on overnight momentum. This worked great though the internet stock boom, but has damaged many traders' accounts since then. I felt this strategy was dead for some time, but it's appreciated to have a "quant" put his paper and pencil to the task...really shows how much has changed. Fortunately, something is always working, so we just move on to the next best expectancy!

Tom Lawrence said...

Awesome, thought-provoking post! This has implications for all kinds of strategies. If it can happen to one...

Johan Lindén said...

Excellent as usual!

Anonymous said...

If the major shift happened 8 years ago, why is it only in the past year that it is having a large effect on trading results? Adjust the position size for volatility and the study will look different.

What you're seeing is that momentum beat mean reversion on a daily level until 1999 or 2000, and since then mean reversion has beat momentum on a daily level. The sudden increase in the rate of fall is because the daily volatility has jumped up, not because the mean-reversion tendency has increased.


Bill Luby said...

Very nicely done, Rob.



Anonymous said...

How about testing a hybrid contrarion strategy: shorting strength and buying weakness? Would be interesting to see how this performed post 2000 relative to the prior two decades.


Anonymous said...

Nice job.

I would like to see the result of Michael's idea.

Woodshedder said...

Great post Rob.

Mac said...

Great article Rob. I guess I know that I am not going totally crazy - it is the market.

heywally said...

Buying weakness and selling strength has been working (usually) for quite a while. One alternative way - from stop losses - to do the money management with this strategy is to combine minimal position sizing with a HIGH level of selectivity in trade choices.

Rob Hanna said...

Thanks all for your thoughts and inputs.

With regards to testing the opposite as Michael suggested - that's easy. Just flip the charts upside down. Or stand on your head while looking at them.

As they were presented, a rising chart line represents an environment where follow through is favored. A downtrending chart suggests reversion strategies would work better. Sideways suggests neither is dominant. Doesn't matter if you're looking at the long trades or short ones. Up is trendy. Down is choppy.


dc said...

jkw nailed it.

LP said...

The problem with the contrarian strategy is that it too may work for a few month and then switch.

While looking at history is nice way to start, it can be dangerous as well. That being said, the contrarian idea is a good thought. The only question is, are there any characteristics that you may find that can help you decide which strategy might be best execute in real time? But then again we may have to subscribe to Rob's service for that :)

PW said...

I am a novice trader. I learned to trade in 2003 as a trend trader, and have been one every since. I did notice that I am having a harder time making a profit this year and this article helped me to see why.

Thanks, PW

Markus said...

Excellent study.

What would be interesting is if this amount of chop is also evident in markets that are generally seen as having a greater element of trendiness, eg the currencies.