Recently I’ve shown that daily stock market mean-reversion is becoming stronger at an accelerating pace and attempted to explain why. Understanding this shift is key to trading short-term swing strategies like RSI(2) or daily follow-through.
Woodshedder (from my blogroll) made a very interesting observation in response to my post. He said that short-term mean-reversion isn’t necessarily accelerating in terms of the percentage of days that close in a given direction (i.e. win %), only in terms of the magnitude of the change when they do (i.e. average return), which could just be a function of increasing volatility in the market.
Here is my response:
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The graph above is calculated in a similar fashion as in my previous posts, a six-year rolling average following either an up close (blue) or down close (red), de-trended to remove the influence of bull/bear markets, on the S&P 500 from 1950.
Rather than looking at next-day average returns, I’m looking at the probability that the next day closed up. I’ve de-trended the result by subtracting the probability that the next day closed up for all days over that same six-year period.
I know it's a little complicated to explain in a blog post, so let me give an example. If over a given six-year period the market closed up 55% of the time, but following a close down it closed up 60% of the time, the red line would read 5%. Got it?
For comparison, below is my original graph using the same methodology, but looking at average returns.
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Response to Wood’s Light Bulb
Daily mean-reversion is becoming stronger both in terms of average return (which we’ve previously shown) AND the probability of the next-day’s closing direction (which the first graph above shows).
HOWEVER, the probability of the next-day’s closing direction (win %) is not accelerating at as aggressive a pace as average return (i.e. the slope of the line is shallower). As Wood alluded to, part of the acceleration in daily follow-through as I showed it previously was a result of increasing volatility in the market in and of itself.
Well done Wood.