Broad market indices are mean reversion animals. First, indices like S&P500 do not behave the same way as momentum stocks. Second, the aggregated market-making activities in the underlying components are magnified in the price movement of the indices over shorter time spans. Third, such basic characteristics can be identified quite easily. Here is a skeleton model applied on (NYSEARCA:SPY) demonstrating how you can profit from this core driver of index price movement.
The Simpleton Counter-Trend Strategy
1. Always in the market
2. AR = average range of SPY over past 6 days
3. AVG = average of SPY close over past 6 days
4. Go long when SPY closes below AVG - 0.2 AR
5. Go short when SPY closes above AVG + 0.2 AR
Following is the net points gained by the model since early 1993.
Notable characteristics of the model:
1. It likes volatility. Performance is better whenever volatility increases.
2. During bullish period, short trades suffer and not producing profit.
3. During bearish period, long trades suffer and not producing profit.
4. The net gain, even excluding the 2008 crisis period, outperform the market significantly
5. Just like many other counter-trend strategies, prices can go against the model significantly before reversing its course, making it difficult to utilize leverage unless you are properly capitalized.
6. Most of the time, prices go against the model for days after entry.
7. The parameters of the model over nearby values all produce excellent performance.
Not Designed for All Indices
Is this strategy applicable to other indices? Not all of them.
This model does not work with (NYSEARCA:DIA). Two factors contribute to this issue; Dow components are linearly weighted based on the price factor alone and that there are only 30 components in the index.
This model does not work that well with (NASDAQ:QQQ), because Nasdaq 100 components are heavily concentrated in the technology sector, thus making it closer to a composite momentum stock than a balanced index.
This model works pretty well with (NYSEARCA:IWM) using a different set of parameters. IWM is diversified enough for the characteristic exploited by the model to affect its price actions.
The Counterintuitive Nature
Many technical traders assume moving averages are useful for confirmation of trends being established. The model I presented here shows that sometimes it is not true. This counterintuitive behavior does not affect the macro picture of the index at all.
This model has the interesting signature of trend following systems that utilize the first pullback as entry, but it is not a trend-following model. The reason is that this strategy does not utilize any trend identification mechanism at all. The fact that the index continues to move against most of the positions after entry is a signature characteristics of counter-trend models.
The short-term accumulation and distribution of inventories by the market makers can be detected by many methods. Using this strategy is one of the quick and dirty ways to see if market makers are exerting strong influence.
This is third installment of the Bankable ETF Strategy series. I did not expect so many responses to the first two articles. To say the least, I am presently surprised. Many thanks to everyone who email me with their ideas on new topics and all kinds of interesting questions.