Tuesday, December 27, 2011

Mean Reversion: What changed in 1987?

Since 8 months I am actively trading some mean reversion strategies as a great diversifier to my intraday trading approach. Until now it worked out quite well.
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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algodude said...

Very interesting post. I'm curious about the time horizon of your RTM strategy: Is it an intraday or EOD system? I trade an intraday RTM strategy and I'd love to see how it performed that far back, but my 1min data only goes back 9 years. Thanks for the great post!

Andreas Marquardt said...

Thanks, at least one person was reading it....
It is a composite of 8 EOD mean reversion systems. Holding period between 2 and 40 days. On Average ~8 days. However most of my other trading is intraday based on daily data. Gaps, candles, ... so partly there is also mean reversion as well as break out patterns. Regarding the data, send me an email if you like....

algodude said...

Thanks for the reply, Andreas. lol, I know how you feel - I have a trading blog myself and seem to get more stealth views than comments.

I currently use PiTrading's historical CDROM set (which has 1min data of futures and both Nas100 and S&P500 stocks going back to 2002) and overlap that with current data downloaded each night from IQFeed (which goes back about 5 years). I'm covered on EOD data, as IQFeed goes back >10 years, but I'd love to incorporate the 1999 bull market and the 2000 meltdown in my 1min historical data. I've found vendors that can supply the older intraday data, but its pretty costly.


quantivity said...

Posting in English helps, Andreas.

Worth noting that lack of comments need not necessarily imply lack of reading.

Andreas Marquardt said...

Thank you for reading. It is a matter of time (and quality) to have more readers, I guess.
I like your blog.

Anonymous said...

AM, congrats for tour blog.
I think things are changed a bit before '87 crash: in '82 was born SP futures (before was very difficoult to short stocks) and I seem to note some form of weekly mean reversion since 1974 on SP index.
But I have no ideas how to solve puzzle