However to diversify also within the strategy set of mean reversion I use different indicators as entry signals like RSI, DV, CCI and Simple vs. Exponential Moving Averages. To improve Draw Down, Hit Ratio and overall system stability I use multiple filters like trend direction, trend strength and the volatility level.
Last week I spoke with Joachim (has also a German blog) about my approach and he showed me long term chart about a common mean reversion strategy posted in a German forum some time ago. I was quite shocked, as I wasn't aware of these very different time periods for mean reversion before and after the crash of 1987. I don't know if this phenomenon is commonly known.
I trade also the eMini S&P, but was only testing back to 1997 for this market. In order to find out how my current setup would have suffered in former times I have tested my S&P mean reversion 'composite' (consisting of 8 different strategies, no leverage here) back to 1963 with index data from Yahoo. It's 1963 because untill '62 the history has no OHLC data, which I need for some indicators and filters.
S&P 500 Index - Mean reversion composite
The results are horrible till the early '90s. From 1963 until 1973 the equity line drops constantly for ten years and is then building a bottom for almost twenty years. Interesting indeed is that since the crash in 1987 the results are much better. It seems that the market has changed somehow dramatically after these two crash days . For futher analysis I have divided the single trades in two parts before and after the market crash end of october 1987.
Looking at the distributions....
|S&P 500 Index - Mean reversion composite / Distribution of returns|
.... and the statistics:
After the crash '87 the mean reversion composite shows almost no skew while the returns of the back tested trades before '87 are negatively skewed. However, because of the market offering more opportunities for mean reversion after '87 the back test shows clearly more trades, while having less return volatility. The two periods show a totally different market environment for mean reversion approaches.
So what changed in 1987, leading to an overall great market environment for mean reversion trades? In the forum -I mentioned above- members were discussing about Alan Greenspan taking the Fed office in early 1987. Mr. Greenspan had for sure a huge impact on the equities markets and may be responsible for the long term bull market between 1987 and 2002. But in my opinion this is to simple. In addition the forum members were talking about the existence of a Plunge Protection Team, buying huge equity in heavily falling markets (and selling them later in rising, I guess) leading to more reversion than before. It would be an almost perfect explanation of this phenomenon. However this is a conspiracy theory....
When I think about what changed in the crash 1987, the black scholes option pricing formula comes to my mind. Before 1987 options were priced with a flat implied volatility by mistake. This changed afterwards. And this might have had huge impact on the behaviour of the hedging of option market makers in the underlying stock markets. But I have no clue how this could work out exactly....
So would do you think? Has anyone a proper explanation for this phenomenon?
So I learned that trading mean reversion style systems shows some nice and stable results, but obviously there is evidence to be very careful in monitoring the market changes that might be coming.
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