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MRSwing:
Aquantitativesystemformeanreversionand
swingtradinginmarketregimes

March2010

DavidAbrams
QuantitativeSystemDesigner
www.daveab.com
dave@daveab.com

ScottWalker
PortfolioManager
www.walkertradingpartners.com
swalker@walkertradingpartners.com
1. Abstract
MR Swing is a quantitative system that employs daily meanreversion and swing trading in different
marketregimestoproduceenhancedabsoluteandriskadjustedreturns(e.g.inoneconfiguration23%
CAGR, 54% risk adjusted CAGR, 1.37 Sharpe, 13% max drawdown). The system uses four key design
principles: marketregimeswitching, non symmetrical trading algorithms, volatility adaptive metrics,
androbustnesstoregimewhipsaws.AnextensiveanalysisofoutofsampleETFsandmanagedfutures
demonstrates the robust performance of the system over ten years. Finally, MR Swing is incorporated
asacomponentinadiversifiedportfolioofETFs(modeledafteruniversityendowments)andisshownto
significantlyincreasetheportfoliosreturnwhilereducingthemaximumdrawdown.
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This paper describes a quantitative method for trading equity indexes (ETFs and futures) that can
increasereturnandreducevolatilitywhenusedinadiversifiedportfolio.Thesystemisdesignedtobe
adaptivetochangesinmarketvolatilityovertheshortterm,andalsodeploystechniquesalignedtothe
dominant market regime. After recapping the robust performance metrics across various ETFs and
futures,wedemonstratehowMRSwingimprovestheperformanceandriskprofileasacomponentina
portfolio with asset class allocations inspired by large university endowments: The Ivy Portfolio (Faber
andRichardson2009).
TheMRSwingsystemisbasedonfourcoreprinciples:(1)Marketregimeswitching,(2)Nonsymmetrical
trading algorithms, (3) Volatility adaptive metrics, and (4) Robustness to regime whipsaws. The first
principle is marketregimeswitching. Markets behave differently in different environments. We
quantifythecurrentmarketenvironmentorregime,andthenadoptatradingapproachbestsuitedtoit.
An example of regime switching (Kestner 2003) uses a trendfollowing method (the 40day/20day
channelbreakout)intrendingmarkets,andcountertrend trading(14dayrelativestrengthindex(RSI))
in nontrending markets. The average directional index (ADX) is used to define the market regime as
trendingornontrending.
Table1:ExampleofRegimeSwitching(Kestner2003)
ADX<20 trendtobeginsoon 40day/20daychannelbreakout
20<ADX<30 meanreversioninprices 14dayRSIstrategy
ADX>30 trendingprices 40day/20daychannelbreakout

In MR Swing we simply quantify two regimes: bull and bear. One could have more complex regimes
based on price volatility, option implied volatility, and other factors. We use a shortterm mean
reversionmethodinthebearregime,andswingtradingtechniqueinthebullregime.
Thesecondprincipleisnonsymmetricaltradingalgorithms.Mosttradingstrategiessimplyreversethe
rules for bull and bear. For example, in Tactical Equity Allocation Model (T.E.A.M.) the system (Lent
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2009) buys shortterm meanreversion on a daily timefame, when the weekly percent trend channel
hashadanupsidebreakout.Thesystemreversestheserulestoshortarallyinthedailytimeframeafter
aweeklychannelbreakdown.Mostcountertrendsystemspickoneoverbought/oversoldoscillatorand
then symmetrically buy oversold and short overbought. These common techniques assume that
markets behave in a symmetrical manner in different market regimes. We show that entirely unique
techniques are more responsive to regime conditions rather than using symmetrical techniques. The
swing trading component uses different algorithms for entries and exits. In addition, we employ
differentmethodsbasedontheregimetomakeanonsymmetricalalgorithm.
Ourthirdprincipleofvolatilityadaptivemetricsrequiresthateachindividualcomponentofthesystem
mustbecapableofrobustlyhandling changesin marketvolatility.Forexample,whenwe quantify the
dominant market regime using a trendfollowing method, we employ a channel based on price to
reducewhipsawsandgetthebenefitsofhysteresis.Next,everymetricweuseformeanreversionand
swing trading entries/exits was carefully chosen to include volatility in the algorithm. In the mean
reversion component, the overbought/oversold levels are calculated using an adaptive technique that
normalizesthedatausingnonparametricstatistics(i.e.wedonotassumethatpricesexhibitaGaussian
distribution).
The final principle is robustness to regime whipsaws. Regardless of the method we use to define the
current market regime, false alarms or whipsaws will occur. Classic moving average trendfollowing
systems are very prone to losses in a sideways market. Instead of trying to eliminate whipsaws in the
regimemodel,weinsteadstructureeachcomponenttobeabletowithstandwhipsaws.Thatmeans,an
entry in the swing trading regime must be able to handle a change to the meanreversion regime
without causing the system to become unstable. MR Swing is designed to address these cases and
ensurerobustnesstochangesinregime,includingwhipsaws.
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2. MeanReversioninEquityIndexes
Themajorequitymarketindicesexhibiteddailyfollowthroughlastcentury,buthavebeenverymuchin
ameanrevertingenvironmentsinceabout2000.Stokesshowed(Stokes06/09/2009and08/10/2009)
howdailyfollowthroughworkedwell1950to2000,butthenitreversed.Wesuggestthatthischange
to meanreversion is due to the increased speed at which news and data is priced into the market. In
particular,computerizedtrading,discountbrokerswithlowcostcommissions,andtheworldwideweb
startedtoreachcriticalmassaround2000.Thesefactorsmayhavestructurallychangedhowtheindices
behaveandarereflectedinoursystemdesign.
In the study below, we compare daily followthrough to daily meanreversion in the S&P 500 equity
index.Therulesforfollowthrougharesimple:iftodayscloseishigherthanyesterdays,thengolong.If
itislowerthanyesterdaythenreverseandgoshort.Dailymeanreversionistheopposite.
Algorithm1:DailyFollowThroughRules
if(C>C
1
)thenbuy
if(C<C
1
)thensellshort
Algorithm2:DailyMeanReversion(MR)Rules
if(C>C
1
)thensellshort
if(C<C
1
)thenbuy

Theresultsofthesetwosystemsoverthelasttenyearsareshownbelow.
Table2:ComparingDailyFollowThroughtoDailyMeanReversion
$100,000portfoliofrom10/01/2000to02/01/2010

System CAGR Sharpe Portfolio


Value
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
MaxDD
DailyFollow
Through
16.20% 1.01 $19,097 7 9 0.82 33.67% 87.30%
DailyMean
Reversion
15.42% 0.78 $383,899 9 7 1.25 66.17% 26.13%

Asyoucansee,dailymeanreversionhasbeenarespectablesystemoverthelasttenyearswith15.42%
compound annual growth rate (CAGR) and 66% of trades profitable with a reasonable drawdown of
26%. The chart below compares the growth of a $100,000 portfolio trading the two systems between
2000and2010.
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We will delve deeper into meanreversion and identify ways to improve on the base system. The
benchmarkforoursystemisthedailymeanreversionsystembecauseofitssimplicityandperformance
metrics.Thesystemthatwedesignmustimproveonthesimpledailymeanreversionshownabovein
ordertojustifytheaddedcomplexity.
2.1. MeanReversioninMarketRegimes
We define market regimes based on a 200day simple moving average. We choose a 200day moving
average based on research done by (Siegel 1998) that showed over the last century a 200day moving
averagefilterwouldhavereducedvolatilityinalongtermstockportfolio.
p
C
=
C
i
N-1
i=0
N
where N = 200 = IFF((C > p
C
),1 , -1 ) (Algorithm 3)
= 1 bull rcgimc = -1 bcor rcgimc
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
$400,000
$450,000
$500,000
Figure1:DailyMeanReversionvs.DailyFollowThrough
DailyFollowThrough DailyMeanReversion
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Belowshowstheresultsofmeanreversioninbullandbearmarketregimes.
Table3:DailyMeanReversion(MR)inMarketRegimes
$100,000portfoliofrom01/05/1999and02/12/2010

System CAGR CAGR


riskadj
Sharpe Portfolio
Value
Timein
Market
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
MaxDD
MRin
Bull
0.69% 1.30% 0.09 $108,346 53% 11 7 1.03 65.36% 21.62%
MRin
Bear
11.89% 28.80% 0.72 $348,498 43% 12 5 1.40 66.02% 26.14%

Daily meanreversion is a more dominant force during a bear market (11.89% CAGR, 0.72 Sharpe)
comparedtobullmarkets.Meanreversionthrivesontheheightenedvolatilityofbearmarkets.

The MR Swing system will be designed to take advantage of the outperformance of meanreversion in
thebearregime,andwewilluseadifferentstrategyinbullregimes.
$0.00
$50,000.00
$100,000.00
$150,000.00
$200,000.00
$250,000.00
$300,000.00
$350,000.00
$400,000.00
Figure2:MeanReversioninMarketRegimes
MRinBullRegime MRinBearRegime
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3. QuantitativeTradingSystem
Whileweuseddataanalysisintheprevioussectionstounderstandmarketstructureforoursystem,itis
important to avoid curve fitting when designing a quantitative trading system (Bryant 2006). In
particular,westartwiththeseguidelines:
Default parameter settings: all indicators and system components should use default values,
insteadofoptimizingthemforthehighestnetprofit.
Avoidoptimization:optimizationwillonlybeusedtotestifasystemcomponentaddsvalue,not
tochoosespecificsettings.
LongTimeframe:wechoosethelasttenyearsasourtimeframe.Thisgivesusenoughdatafora
robustanalysis,andalsokeepsustradingthecurrentmarket,andnotlastcenturysmarket.
ManyTrades:trendfollowingsystemthatonlytradeafewtimesperyearmayhavedrastically
differentresultsifyoumissasmallsampleoftrades.Wepreferasystemthatgeneratesmany
trades (e.g. MR Swing generates ~400 trades in the current analysis) because this adds to our
confidencethatsystemresultsarenotoverlyinfluencedbyasmallsetoftrades.
OutofSampleTesting:weoriginallydesignedthesystemfortheSPY,andwillshowtheoutof
sampleresultsontheQQQQ,EEM,EWM,VTIaswellasthefutures@ESand@NQ.
Our system design starts with the core principles outlined in the introduction: (1) we exploit different
characteristicsofmarketsbyusingamarketregimeswitchingmethodtotakeadvantageofshortterm
meanreversion in the bear regime, and deploy swing trading in the bull regime. Next, we will employ
(2) non symmetrical trading algorithms for entries, exits and the regime specific trading algorithms.
Everysystemcomponentmustbebasedon(3)volatilityadaptivemetricssothatitcanhandlechanges
involatilityoveralongtimespan.Finally,werecognizethatnoregimeswitchingmodelwillbeableto
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eliminate all false signals and each core system component must exhibit (4) robustness to regime
whipsaws.
3.1.QuantifyingMarketRegimes
There are many ways to define the market regime. A complete study of different market regimes is
beyond the scope of this paper. MR Swing identifies market regimes based on a 200day moving
averagechannelofthehighsandlows.Whenthesystemisinthebullregime,itonlyallowsthechannel
toincrease,andviceversainbear.Thereasonwechooseachanneloverjustamovingaverageistoget
thebenefitsofhysteresis(Alves2009)andreducewhipsawsbyusingarangeofvaluesbeforeswitching
frombulltobearregime.
Hysteresis (Hysteresis 2010) is a natural phenomenon that appears in magnetism, elastics, cell mitosis
and control theory (e.g. thermostats). These systems exhibit path dependence in which the current
state depends on the path taken to achieve it. The system has memory and the effects of the current
inputareonlyfeltafteradelayorrangethresholdisexceeded.Webelievethatmarketsalsoneedtime
to respond to new information and that response does take into consideration recent market history.
Our market regime filter requires price to close below the low of the channel before switching into a
bearregime.
Algorithm4:MovingAverageTrendChannel

p
L
=
L
i
N-1
i=0
N
p
H
=
H
i
N-1
i=0
N

p = IFF( = 1, NAX(p
L
, p), HIN(p
H
, p))

= IFF(C > p, 1, -1)

default N= 200
Simple moving average channel of the bar highs and lows. A bar close below the trailing channel
switches it to a down trend ( = 1). In an uptrend ( = 1) we only allow to increase, such that in
sidewaysmarketorretracementdoesnotchange.

ThemarketregimemodelshownbelowinFigure3isfrom2005to2010onadailychartoftheSPY.
Figure3:MarketRegimeTrendChannelonSPYfrom2005to2010
200daySMAchannelofbarhighsandlows(incrementonlyindirectionofthetrend).

This technique captures the major market trends with fewer whipsaws than using the traditional 200
daySMA.Insteadofattemptingtodesignalongtermmarketregimefilterthatremovesallwhipsaws,
werequireeachcomponenttoexhibit(4)robustnesstoregimewhipsawsinthecoretradingalgorithm.
Akeydesigninthealgorithmisnottoexitapositionjustbecausethedominantmarketregimechanged.
Instead, we hold on to the position, and simply change the entry/exit rules based on the new regime.
Themeanreversionandtheswingcomponentsmustbeabletohandlethisbehaviorwithoutaserious
drawdown. This is one reason the system structure is designed for major equity market indexes as
opposedtoindividual(especiallyilliquid)equities,whichmayhaveapriceshockduetoastockspecific
news announcement. MR Swings patience in waiting for a high probability exit to the trade after a
regimechangehasbeenextensivelytestedandshowntogreatlyimproveintheequitycurve.

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3.2.BearRegime:ShorttermMeanReversion(MR)
Wecanimproveonthedailymeanreversionsysteminsection 2byemployinganadaptiveshortterm
meanreversion algorithm. Some quantitative systems have used a two period relative strength index
RSI(2)fordailymeanreversion.AlthoughthiswouldworkfineinMRSwing,wechoosetheDVO(David
Varadi Oscillator, 2009) because it meets our principle of a (3) volatility adaptive metric. The Percent
Rankfunctionisusedtonormalizethedailydata,andthisnonparametrictechniquerobustlyadaptsto
marketvolatilitychanges.
Algorithm5:GeneralizedDVOandDV2

0(w, x, N) = |
C

(E

w
0
+I

w
1
+ 0

w
2
+C

w
3
)
N-1
=0
] - s

wbcrc s

= 1
N-1
=0
onJ w
]
= 1
3
]=0

DFO(w, x, N, H) = PcrccntRonk(0(w, x, N), H)

Jcoult N = S onJ H = 2S2

DF2 = DFO(|u.S u.S u u], |u.S u.S u u u], S, 2S2)

TheDavidVaradiOscillator(DVO)wasdesigned(Varadi07/29/2009)tobeashorttermoscillatorusingbarhighs
and lows (maximum smoothing period N=5). The DV2 is one specific setting originally designed for the SPY (the
weighting period was 50/50 over the last two days). The DVO can be used to create unique weighting schemes
thatfunctionbestforeachclassofsecurityanddefinealocalweightdensity(w x) fortheETForfuturescontract.
Itcapturesdifferentcyclelengths,amplitudes,andreturndistributionsofthesecurity.

The DVO gives us the flexibility to customize the system to the different cycle lengths, amplitudes and
return distribution of the particular security. Although we use the default values of the DV2 shown
above,MRSwingsperformancecouldbeimprovedusingthisreadilyavailablefeatureoftheDVO.The
chart below shows the DVO in the meanreversion component of MR Swing between 02/2008 and
08/2008.ThesystembuysthenextdayopenwhenDVOislessthan40%andshortsthenextdayopen
whenDVOisabove70%.Themagentalineaboveshowsthemarkettrendchannel.
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Figure4:MeanReversion(MR)TradesinBearRegime
UsingDVOonSPYfrom02/2008to08/2008

MRSwingactualtradesontheSPYin2008duringthebearregimetodomeanreversionusingtheDVOwithdefaultsettingsof
theDV2.

3.3.BullRegime:SwingTrading
Therearemanymethodsforswingtradinginbullmarkets.One systematicwayofdiscretionaryswing
tradingusingmultipletimeframesistheTripleScreensystem(Elder1993).First,thelongtermtrendis
determined by requiring that the security must show positive momentum on the weekly timeframe
(moving average convergence divergence (MACD) histogram for this week is higher than last week).
Next,themarketshorttermtrendonadailychartisusedtoidentifyapullbackusinganoscillator(e.g.
Elders Force Index). The third and final screen is to put in a trailing buy stop at the highs of the bars
untilfilled.Theinitialstoplossisatthelowofthepreviousbar.
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WetakeourinspirationforMRSwingsquantitativealgorithmfromtheTripleScreensystem.First,the
dominantmarketregimemustbeabullswingtradingenvironment(Section3.1).Second,welookfora
pullback entry (Section 3.3.1). Third, we patiently use a limit order entry technique (Section 3.3.2).
Exitsemployanintermediatetermexhaustionindicator(Section3.3.3).
Figure5:SwingTradesinBullRegime
SPYfrom06/2009to02/2010
ValueChartoversoldisusedforentries.SVAPOoverboughtsignalsexhaustionpointsfortheexits.Noticetheregimechanged
from bear to bull in June 2009, switching from shortterm MR to swing trading. Also the system handled the false alarm
whipsawsinJune/July.

3.3.1.SwingEntryinBullRegime
Wehavefoundthroughexperiencethatbullmarketstendtohavequick,sharppullbacksandthenslow
grinding moves higher. This observation leads us to choosing a non symmetrical trading algorithm for
swingtrading. Entriesuseavolatility adaptivemetricthatissuitedtofindingfastpullbacks,andexits
use an intermediateterm exhaustion method that includes price and volume. We choose the Value
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Chart(HelwegandStendahl,2002)forentriesbecauseitdynamicallyidentifiesoverboughtandoversold
levelsevenwhenpricevolatilitychangesovertime.Firstarelativepricechartiscreated,similartoade
trendedpriceoscillator.Then,itisadjustedbyadynamicvolatilityunit.
Algorithm6:ValueChart

y(i) = IFF( (|C

- C
-1
| > E

-I

), |C

- C
-1
|, E

- I

v=
y(i)
N-1
=0
N
- o Jynomic :olotility unit

p =

(E
]
+ I
]
)
2
,
N-1
]=0
N
looting oxis o rcloti:c pricc :oluc

I
0
=
0-
v
I
L
=
L-
v

I
H
=
H-
v
I
C
=
C-
v

wbcrc o = u.16, N = S

Relative price chart that adapts to changes in market volatility. The value chart of the close is the
distance between the close and the floating axis of relative price value (mean of the median price)
dividedbythedynamicvolatilityunit(meanofthebarrange).

WeusethedefaultN=5barperiodfortheValueChart.Anoversoldlevel(7.5)isbasedonthelowsof
thebars,soweareonlyusingI
L
inthealgorithmtosignalapotentialpullbackentrypoint.
3.3.2.LimitOrderEntryTechnique
MRSwingusesextremepatienceinentriesandexits.Limitordersareusedinswingtradingtoattempt
togetanentryclosetothelowofarecentbar.
Algorithm7:LimitOrderEntries
e
Lnt
= IFF((I
1
< I
2
), I
1
, I
2
)

Eachbarthelimitordertargetpriceisrecalculatedtodynamicallyadaptto
recentpricechangesandsearchforanentry.MRSwingpatientlywaitsfor
thetargetpriceofthelowestlowofthelasttwobars.

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Sometimesanentryismissedbecauseofthistechnique,butMRSwingislookingforlowriskentriesat
theexpenseofpotentiallymissingatrade.
3.3.3.SwingExitinBullRegime
Asaquantitativesystem,MRSwingneedsaprecisedefinitionofmarketexhaustionwhenswingtrading
thebullregime.Wechooseavolumeandpriceoscillator(Vervoort2007)thatmeasuresexhaustionby
combiningtheshorttermpricetrendwiththeslopeofthevolumeovertime.
Algorithm8:VolumeandPriceOscillator(SVAPO)
SVAPO(Period=8, Cutoff=1, StDevH=1.5, StDevL=1.3, StDevPeriod=100)

//Vervoorts Heiken-Ashi is smoothed short-term price trend
AP = AVGPRICE; // (O+H+L+C)/4
haO =0.5*(AP[1]+haO[1]);
haCl =0.25*(AP+haO+MAXLIST(AP,MAXLIST(High,haO)) + MINLIST(AP,Minlist(Low,haO)));
haC = TEMA(haCl,0.625*Period); //triple exponential moving ave of Heiken-Ashi close

//volume delta at each price (handle volume extremes)
VolumeValue = IFF(BarType<2, Ticks, Volume);
VAvg = AVERAGE(VolumeValue[1],5*Period);
VMax = 2*VAvg;
Vc = IFF(VolumeValue<VMax,VolumeValue,VMax);

//basic volume trend is triple exponential moving average of linear reg slope of volume
VTrend = TEMA(LINEARREGSLOPE(VolumeValue, Period),Period);

//Day Trend=UP if smoothed Heiken-Ashi and volume trend higher than previous bar
Up = haC>haC[1] * (1 +(0.001*Cutoff)) and COUNTIF(VTrend >= VTrend[1],2)=2;
Dn = haC<haC[1] * (1 -(0.001*Cutoff)) and COUNTIF(VTrend <= VTrend[1],2)=2;

//SVAPO is triple exponential moving average of the summation of volume
//each days volume contribution depends on trend for that day
//UP days add the volume, DOWN days you subtract volume for that day from the sum
DELTA_SUM= SUMMATION(IFF(Up,Vc,IFF(Dn,-Vc,0)),Period)/(VAvg+1)
SVAPO = TEMA(DELTA_SUM,Period);

//dynamic bands using standard deviation of SVAPO over time
UpperBand = StDevH*STDDEV(SVAPO, StDevPeriod);
LowerBand = -StDevL*STDDEV(SVAPO, StDevPeriod);

TradestationEasyLanguagecodeisshownforVolumeandPriceOscillator(SVAPO)adoptedfrom(Vervoort2007).
UpperandlowerbandsaregeneratedaroundtheoscillatorbasedonstandarddeviationsfromtheSVAPOmean,
inordertomaketheindicatordynamictochangesinmarketvolatility.WhenSVAPOclosesabovetheupperband
itsignalsanoverboughtmarket.

Using the default settings, the SVAPO tends to find excellent exhaustion points in the bull regime by
combining shortterm price trend and the slope of the volume trend. Note that we do not wait for
confirmation of an exhaustion point like the traditional SVAPO system, instead we start looking for an
exitusingourlimitordertechnique(Section3.3.4)whenSVAPOcrossesabovethetopband.
15

3.3.4.LimitOrderExitTechnique
Similar to entries MR Swing uses extreme patience looking for a high probability exit. Limit orders are
usedinswingtradingtoactivelysearchforanexitclosetothehighofarecentbar.
Algorithm9:LimitOrderExits

e
Lxt
= IFF((E
1
> E
2
), E
1
, E
2
)

Eachbarthelimitordertargetpriceisrecalculatedtodynamicallyadaptto
recent price changes and search for an exit. MR Swing patiently waits for
thetargetpriceofthehighesthighofthelasttwobars.

MRSwingkeepssearchingforalimitorderexitoneachbar.Wealsotestedapplyingatrailingstopset
at the simple moving average of the lows of the last 2 bars. This combined with the limit order exit,
provides a balanced approach to exits that most times hit the limit order, and uses the trailing stop to
protectprofits.
4. CompositeStrategyandPerformanceResults
Nextwewillcombineeachcomponentofthealgorithmintoanendtoendautomatedtradingstrategy.
Thecomponentswillbetestedinthreedifferentvariations,shownbelow:
Table4:Strategy Rules

MRSwing(counter)
Aggressive

Takeallcountertrendtradesinallregimes.Alwaysinthemarket
(longorshort)unlessstoppedoutforthattrade.

BearRegime:golongandshortMRrules
BullRegime:golongandshortswingtraderules

MRSwing(swinglong,MRcounter)

TakeallcountertrendtradesinbearregimeusingMR.Swingtrade
longonlyinbullregime,donotshortabullmarket.

BearRegime:golongandshortMRrules
BullRegime:swingtradeloneonly(nevershort)

MRSwing(nocounter)
Conservative
Conservativesystemthatonlytradesinthedirectionofthedominant
marketregime.Nevercountertrendtrade.

BearRegime:sellshortusingMRrules(neverlong)
BullRegime:golongswingtrades(nevershort)

16

Wecompareanaggressivesystemthattakesallcountertrendtradesinbothbullandbearregimes.A
countertrendtradeintheswingtradingsystemissimplytosellshortinsteadofexitingwhenthelimit
orderpriceisfilled(Section3.3.4).ThenexttableshowstheperformanceofMRSwingontheSPY,an
ETFthatfollowstheStandardandPoors500IndexoflargecapitalizationUSstocks.
Table5:MRSwingonSPY
$100,000portfoliofrom02/01/2000to02/12/2010

System CAGR CAGR


riskadj
Sharpe Portfolio
Value
Timein
Market
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
Max
DD
MRSwing
(counter)

37.90% 38.34% 1.58 $2,484,277 98.81% 17 6 2.81 69.47% 23.65%


MRSwing
(swinglong,
MRcounter)
35.16% 51.25% 1.54 $2,068,616 72.79% 17 6 2.75 69.43% 21.68%
MRSwing
(nocounter)

23.07% 54.06% 1.37 $801,735

48.01% 15 3 3.25 74.23% 13.09%

Thefullcountertrendsystemisinthemarket98.8%ofthetime(usinga20%pertradestoplosscauses
it to be out of the market 1.2% of the time). It shows a solid 37.9% compound annual growth rate
(CAGR) and Sharpe of 1.58 with a max daily equity drawdown of 23.65%. Note that the drawdown
figuresaremarkedtomarketeverytradingday,sothatyoucanseethetruedrawdown(asopposedto
monthly figures or a tradebytrade figure). The system reinvests the entire portfolio on every trade.
Commissionsandtaxesareexcluded.Slippageisexcluded,butwastestedasinsignificantduetoentries
andexitswithlimitorders.
TheconservativeversionofMRSwingtakesnocountertrendtrades.Itisonlyinthemarket48%ofthe
time, and it still delivers 23% CAGR and the max drawdown is greatly reduced to 13%. Taking trades
onlywiththetrendalsoreducesthenumberofconsecutivelosingtradestojustthreeoverthelastten
years. This is a key pragmatic issue for any manager or trader following an automated system, since
thereisawellknowntendencyforinvestorstowithdrawfundsandtraderstoturnoffthesystemifthe
17

number of consecutive losses leads to a lack confidence in the system, often just before the system
recovers (How many consecutive losing trades will you suffer before turning off the system?). We
believethatthisisoneofthekeystrengthstoemployingMRSwinginlivetrading.
The next chart shows the performance of MR Swing, markedtomarket daily, over the last ten years.
The conservative system shows much lower drawdown, but between 2004 and 2006 performance was
flat. The system compounds portfolio equity by reinvesting profits, which accelerated 2008 and 2009
returns.


$100,000
$200,000
$400,000
$800,000
$1,600,000
$3,200,000
Figure6:MRSwing SPY
MRSwing(counter)37.90%CAGR
MRSwing(swinglong,MRcounter)35.15%CAGR
MRSwing(nocounter)23.07%CAGR
18

5. MRSwing:ExchangeTradedFunds(ETFs)
MRSwingwasoriginallydevelopedfortheSPY.WetestedtheoutofsampleresultsonotherETFsand
foundarobustsystemperformanceacrossdifferentgeographicalandmarketsizeindexbasedETFs.
Table6:MRSwing(counter)ExchangeTradedFunds07/2000to02/2010

Sym CAGR CAGR


riskadj
Sharpe Portfolio
Value
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
MaxDD
Emerging
Markets
EEM 24.76% 25.18% 0.69 $365,399 10 4 1.46 64.46% 37.63%

Russell2000
SmallCaps
IWM 14.60% 14.69% 0.60

$322,973 13 4 1.61 65.89% 45.07%

Nasdaq100
LargeCap
QQQQ 36.88%

37.27%

1.12 $2,083,961 10 5 1.74 67.23% 23.16%


Vanguard
TotalMarket
VTI

28.56% 28.95% 1.33 $697,403 10 6 2.05 65.51% 19.93%

Nextweconsidertheconservativeversionthattakesnocountertrendtrades.
Table7:MRSwing(nocounter)ExchangeTradedFunds07/2000to02/2010

Exchange
TradedFund
Sym CAGR CAGR
riskadj
Sharpe Portfolio
Value
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
MaxDD
Emerging
Markets
EEM 4.59% 8.82% 0.19 $130,031 8 5 1.13 60.00% 41.83%

Russell2000
SmallCaps
IWM 13.70% 27.10% 0.78 $301,865 10 4 2.07 68.15% 27.68%

Nasdaq100
LargeCap
QQQQ 29.25% 66.90% 1.28

$1,196,429 9 4 2.29 72.28% 15.93%


Vanguard
TotalStock
Market
VTI

16.40% 34.84% 1.07 $323,548 8 4 2.27 66.43%

13.57%

NoticeagaintheoutofsampleETFresultsofthenocountersystemshowmuchlowermaxdrawdown,
and still a solid rate of return. Max consecutive losing trades of both aggressive and conservative
systems are between 4 and 6, making this a tradable system. In particular, QQQQ shows a 29%
compoundannualgrowthrate(CAGR),1.28Sharpe,77%profitabletrades,and16%maxdrawdown.
19

6. MRSwing:ManagedFutures
We tested MR Swing on outofsample data on the @ES and @NQ futures contracts. Futures provide
the benefits of excellent liquidity, low cost commissions, flexible use of leverage, and tax advantages
overETFs(e.g.marktomarketresults60%longtermcapitalgainsand40%shortterm).Oneimportant
difference in trading futures is our limit orders for entries and exits may get filled in overnight trading.
We have found that overnight order fills to be another positive for trading MR Swing in a managed
futureaccount.
Fixedfractional(FF)moneymanagementisusedat$50,000percontract,andalso$25,000percontract.
That means the system starts trading 2 contracts and 4 contracts respectively. The fixed ratio money
managementsystemtradesaggressivelyforasmallaccountthengetsmoreconservativeastheaccount
sizegrows.Forexample,$10,000getsonecontract.Thenitneeds20Kforthenextcontract.At30Kit
istrading2contracts,andneeds30Kmoreinprofitforthethirdcontract,etc.
Table8:MRSwing(counter)$100,000portfoliofrom07/19/2000to02/22/2010

Sym Money
Mgt
CAGR CAGRrisk
adj
Sharpe Portfolio
Value
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
MaxDD
ES Fixed
Ratio
34.76%

35.41%

1.14

$1,839,589

14 4 2.56

67.75%

46.43%
ES FF
50K/ctr
28.96%

29.49%

1.26 $1,197,509

14 4 3.18

67.75%

22.24%
ES FF
25K/ctr
70.12%

71.59%

1.28 $17,892,862 14 4 4.60 67.75%

46.59%
NQ

Fixed
Ratio
28.01%

28.26%

0.89

$1,091,448 9 4 1.68

68.41%

33.84%
NQ FF
50K/ctr
19.90%

20.07%

0.95

$579,387 9 4 1.72

68.41%

21.37%
NQ FF
25K/ctr
43.26%

43.66%

0.98

$3,243,852 9 4 1.74 68.41%

42.09%

The aggressive version of MR Swing on the ES and NQ contracts with fixed fractional and fixed ration
moneymanagementisshownbelow.Weincluded$2.30percontractforcommissions.
20

One would expect the 25K/contract results to be approximately twice the 50K/contract system. Our
testsshowed70.12%CAGRvs.28.96%CAGR.Sincetwicethe50K/contractresultswouldbe60%,where
did the extra 10% come from? This is due to the interval. A $100,000 portfolio has to accumulate
another $50,000 before trading a 3
rd
contract. The 25K/contract system more quickly adds contracts.
Notice in the chart below the growth of the 25K/contract system, compounding 70% per year turns a
$100,000 portfolio into $17.8M over ten years. We leave this as an option for the aggressive traders
interestedinMRSwing.
$50,000
$100,000
$200,000
$400,000
$800,000
$1,600,000
$3,200,000
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Figure7:MRSwing(counter)ManagedFutures
withDifferentMoneyManagement
NQ50K/contract NQ25K/contract NQFixedRatio
ES50K/contract ESFixedRatio
21

Inthenextsection,wewillshowhowMRSwingcanbeusedtomakeamuchmoreconservativesystem
thatstillgivessolidreturns.
Table9:MRSwing(nocounter)$100,000portfoliofrom07/19/2000to02/22/2010

Sym Money
Mgt
CAGR CAGRrisk
adj
Sharpe Portfolio
Value
Max
Wins
Max
Losers
Profit
Factor
Percent
Profitable
MaxDD
ES Fixed
Ratio
26.66%

57.22%

1.21 $1,004,598 18 4 3.03

70.59% 23.20%
ES FF
50K/ctr
18.52%

38.45%

1.11 $525,439 18 4 3.50

70.59% 10.71%
ES FF
25K/ctr
45.65% 105.41% 1.23 $3,927,298 18 4 4.48 70.59% 21.86%
NQ

Fixed
Ratio
24.46% 50.61% 0.98

$831,042 11 4 2.44

74.77% 29.06%
NQ FF
50K/ctr
16.41% 32.89% 1.04 $435,128 11 4 2.51 74.77% 16.38%
NQ FF
25K/ctr
37.45%

81.38%

1.12 $2,173,202 11 4 2.57 74.77% 34.23%

$50,000
$100,000
$200,000
$400,000
$800,000
$1,600,000
$3,200,000
$6,400,000
$12,800,000
$25,600,000
Figure8:MRSwing(counter)ManagedFuturesES
withFixedFractional$25,000/contract
MRSwing(counter)ES25K/contract
22

The conservative version of MR Swing in a managed futures account shows exciting results. In
particular,wecanpickalowdrawdownversionof50K/contract(10.71%forES,16.38%forNQ)andstill
getexcellentannualreturns(18.52%CAGRforES,16.41%CAGRforNQ).Further,ifweuseleverageon
the conservativesystem, 25K/contract,wedoubleourmax drawdown,andgetevenmorethan2Xthe
performance(45.65%CAGRforES,37.45%CAGRforNQ).

7. CreatingPortfolioSynergy
Modern Portfolio Theory asserts that assembling diversified assets with low or negative correlations
createsaportfolioofcollectivelylowerriskwithoutsacrificingreturn;effectivelyafreelunch.TheIvy
Portfolio (Faber and Richardson 2009) illustrated a meanvariance portfolio that uses noncorrelated
indexestoproduceamuchbetterabsoluteandriskadjustedreturn.Theassetallocationsaremodeled
$50,000
$200,000
$800,000
$3,200,000
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Figure9:MRSwing(nocounter)ManagedFutures
withDifferentMoneyManagement
NQ50K/contract NQ25K/contract NQFixedRatio
ES50K/contract ES25K/contract ESFixedRatio
23

aftertheHarvardandYaleendowments,whichinvestmoreheavilyinrealassets(commoditiesandreal
estate),absolutereturnsfunds,andprivateequitythantraditionalstockheavyportfolios.Additionally,
The Ivy Portfolio showed that combining low correlated assets with long term timing rules both
increasedreturnanddecreasedvolatilityoverabuyandholdstrategyofthesameassets.
Lintner(1983)wrote:thecombinedportfoliosofstocks(orstocksandbonds)afterincludingjudicious
investmentsinleveragedmanagedfuturesaccountsshowsubstantiallylessriskateverypossiblelevel
of expected return than portfolios of stocks (or stocks and bonds) alone. We demonstrate how
combining and employing a set of noncorrelated strategies achieves substantial improved returns and
lower drawdowns. To achieve this we substitute a 20% portion of portfolio assets to our MR Swing
tradingsystemfortheabsolutereturnportionoftheendowmentsassetmix.Integratedintothebase
allocation of the Ivy Portfolio, this raises the CAGR by a factor of 1.7 while cutting the maximum
drawdownby3/5thscomparedtotheIvyETFswithTimingreturns.
7.1IvyPortfolio
In order to compare the Ivy Portfolio with timing to MR Swing and a blended approach, we first align
dataandtimeperiods.TheIvyPortfolioisbasedonabasketofequallyweightedindexes:
1. UnitedStatesequitymarket(S&P500)
2. MorganStanleyCapitalInternationalEAFEIndex(MSCIEAFE),
3. GoldmanSachsCommodityIndex(GSCI),
4. NationalAssociationofRealEstateInvestmentTrustsIndex(NAREIT),
5. UnitedStatesgovernment10yearTreasurybonds

To facilitate backtesting comparisons with our models on a comparable basis, we test the concepts
against tradable market instruments. To that end, we identified the following instruments for our
versionoftheIvyPortfolio.

24

Table10:IvyPortfolioInstruments

1. Vanguard500IndexInvestor(VFINX)
2. VanguardTotalInternationalStockIndex(VGTSX)
3. ThomsonReuters/JefferiesCRBIndex,acommoditypriceindex
1

4. VanguardREITIndex(VGSIX)
5. VanguardIntermediateTermBondIndex(VBIIX)
2

TradableETFsusedtoconstructtheIvyPortfolio.Thetestingperiod
covers8/1/2000through1/29/2010.
3

WemodeledanETFversionofTheIvyPortfolioforbuyandhold,withanequalallocationoffundsper
asset and a yearly rebalance period. We compared that to the Ivy Portfolio using basic timing rules:
The assets portion of the portfolio is fully invested in the asset when the closing price is above the 10
monthmovingaverage;itgoestocashwhenitisbelow.Cashismodeledatthe30dayTBillaverageof
approximately2.2%andweincludenormalcommissionsforadirectaccessbroker($.005/share).
The Ivy Portfolio diversification adds significant value vs. a buy and hold of the S&P 500 in both return
and drawdown. After implementing the timing rules with The Ivy Portfolio it increases performance
versus Buy & Hold, adding 3.4 to the annualized return each year while dropping the maximum
drawdownfrom30tounder12%
4
.
Table11:IvyBuy&HoldversusTimingResults
8/1/2000to12/31/2009
CAGR Sharpe MaxDD
SPY(S&P500)Buy&Hold

2.48%

0.16

56.49%

IvyBuy&Hold

5.05%

0.26

29.83%

Ivyw/Timing

8.45%

0.99

11.65%

1
TheCRBistheonlyexceptionofnotbeingdirectlytradableinthisform.CommoditybasedETFs/ETNsdonothavesufficient
historyforourpurposes,butDBCcouldbeusedtoday(althoughtheproblemofrollyieldfromcontango/backwardationisnot
solved).
2
VanguardIntermediateTermBondIndexchosenasTreasuryETFwithsufficienthistorynotavailable.
3
8/1/2000isthefirstperiodwhendataisavailableforallinstrumentsinoursystems.
4
BoththeIvyBuy&HoldandIvyw/TimingusetheinstrumentsfromTable10.
25

7.2IntegratingResultsofManagedFuturesintoIvyPortfolio
Measuring the correlations using the monthly delta of the equity curve values, several of the
subcomponents of the Ivy Portfolio have low cross correlations, particularly the commodities and the
bonds. MR Swing futures components, NQ and ES, balance each other nicely with only an r= 0.39
correlation. Of greater importance, MR Swing components have low and often negative correlations
withtheIvyPortfoliocomponents.Wewillseehowtheselow/negativecorrelationsenhancedtherisk
basedmetrics(Sharpeanddrawdown)asweputthepiecestogethertoenhancetheportfoliosstability.

MR Swing trading the Futures with ES and NQ work well together since they respond differently to
marketmoves,withtheSharpe,maximumdrawdownandvolatilityallimprovingonthecombinedbasis.
Table13:CombingFuturesMRSwing(nocounter)FixedRatio
8/1/2000to1/28/2010
5

Sym CAGR Sharpe MaxDD Volatility


ES 28.00% 1.25 15.86% 19.2%
NQ 26.42% 1.05 14.65% 20.9%
CombinedNQ+ES 27.26% 1.29 11.56% 17.7%

Next,weincludetheconservativeversionofMRSwing(nocounter)managedfutures,withasmall10%
allocationeachtoESandNQ,usingfixedratiomoneymanagementintothecombinedportfolio.

5
InTables11to14thesystemsaremarkedtomarketusingmonthlydata(Sharpe,MaxDD,andVolatility)tomatchtherestof
theIvyPortfolio.
CRB VBIIX VFINX VGSIX VGTSX MRSwing@NQ MRSwing@ES
CRB 1.00
VBIIX 0.13 1.00
VFINX 0.24 0.02 1.00
VGSIX 0.21 0.16 0.62 1.00
VGTSX 0.26 0.10 0.89 0.64 1.00
MRSwing@NQ 0.14 0.09 0.37 0.16 0.30 1.00
MRSwing@ES 0.32 0.07 0.47 0.30 0.43 0.39 1.00
Table14:CrossCorrelationofIvyPortfolioComponentsandMRSwingFutures
26

Werebalancebacktothe10%allocationtoESandNQatthebeginningofeachyear.Includinga1/5
th

allocationtoMRSwingintothecombinedportfoliodrivesanimpressiveincreaseof5.5pointsofCAGR,
0.7Sharpe,cutsthedrawdownby3/5
th
,whileonlyincreasingvolatilityby0.2%!
Table14:CombingIvyw/Timing&MRSwing
8/1/2000to1/28/2010
Portfolio CAGR Sharpe MaxDD Volatility
Ivyw/Timing 7.92% 0.89 11.65% 6.6%
Ivy+NQ+ESMRSwing
w/Rebalancing 13.41% 1.60 4.48% 6.8%
ChangeDuetoMRSwing +5.49 +0.70 +7.17 +0.2

MRSwing
@ES
10%
MRSwing
@NQ
10%
DomesticStocks
(VFINX)
16%
InternationalStocks
(VGTSX)
16%
Commodities(CRB)
16%
RealEstate(VGSIX)
16%
Bonds(VBIIX)
16%
Figure10:IvyPortfolio+MRSwing
27

We are not using the Futures to hedge the portfolio, but rather as a source of negatively correlated
positive returns. Blending a base of lowcorrelated assets (The Ivy Portfolio) with a noncorrelated,
marketregimeswitchingandvolatilityadaptivetradingsystem(MRSwing)createsapowerfulsynergy.
Theresultissuperiorandsaferreturnsthananyofitsindividualparts.

$0
$50,000
$100,000
$150,000
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$250,000
$300,000
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$400,000
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RebalIvy+NQ+ES
Ivyw/Timing
28

8. Conclusion
MR Swing is a quantitative system that employs daily meanreversion and swing trading in different
market regimes. Over the last ten years, it showed a robust equity curve (37.90% CAGR, 1.58 Sharpe,
23.65% max drawdown) on the SPY. Removing countertrend trades cut the maximum drawdown in
halfandproducedexcellentriskadjustedreturns(23%CAGR,54%riskadjustedCAGR,1.37Sharpe,13%
max drawdown). In addition, MR Swing was tested using managed futures in various money
management configurations. The conservative nocounter setup with leverage (25K/contract fixed
fractional) produced solid results on the @NQ and @ES (45% CAGR, 105% risk adjusted CAGR, 1.23
Sharpe,21.86%maxdrawdown).MRSwingalsotestedwellonawiderangeofETFs.
The system is based on four core principles: (1) a marketregimeswitching method to exploit different
characteristics of markets by using shortterm meanreversion in the bear regime, and deploy swing
tradinginthebullregime.Next,ituses(2)nonsymmetricaltradingalgorithmsforentries,exitsandthe
regime specific trading algorithms. Every system component is based on (3) volatility adaptive metrics
thatit canhandlechangesinvolatility overalongtimespan.Finally,sincenoregimeswitchingmodel
willbeabletoeliminateallfalsesignals,eachcoresystemcomponentexhibits(4)robustnesstoregime
whipsaws.
Finally, we included MR Swing as a 20% component into a diversified portfolio of low correlation ETFs
based on the Ivy Portfolio, modeled after university endowments. MR Swing increased the combined
portfolioCAGRbyafactorof1.5whilereducingthemaxdrawdowntoonly4%.Thisdemonstratesthat
investors will benefit by including a portion of their funds to a noncorrelated systematic approach to
smoothandprotecttheirportfolioperformance.
29

9. Acknowledgements
Thanks to our excellent reviewers: Beth Borchers (editor), David Varadi (quant), Hardin Abrams
(engineer), Lee Girer (engineer/finance), and Ted Schnur (professional trader). TradeStation 8.7 was
used to generate the trade charts. AmiBroker was used to simulate the Ivy Portfolio from Yahoo data
source(includingdividends).MicrosoftExcel2007wasusedtogeneratemostcharts.
10.Glossary
CAGR Compoundannualgrowthrateisthesmoothedyearoveryeargrowthrateofthesystem.Itcovers
theentiretimeperiod.

CAGRriskadj. Riskadjustedcompoundannualgrowthrateistheyearoveryeargrowthrateofthesystem,butit
onlycountstimeinvestedinthemarket.

DVO DavidVaradiOscillator(DVO)measuresshorttermmarketmovements(Varadi2009)

FixedFractional(FF) Fixedfractionalmoneymanagementisamethodofreinvestingprofitsinafuturestradingaccount
(numcontracts=Floor(portfoliovalue/dollarspercontract)

FixedRatio Fixedratiomoneymanagementisamethodofreinvestingprofitsinafuturestradingaccount.The
moretheportfoliogrowsthemoreconservativeitbecomesinaddingnewcontracts.

MaxDD Maximumpercentagedrawdownofthesystemfrompeaktotroughoverthetimeperiod.Inour
analysistheequitycurveismarkedtomarketdailyinsteadofjustatthestart/endoftradesinorderto
showthetruemaximumdrawdownpotential.Onlysection7ontheportfoliousesmonthlyfigures
becausetheIvyPortfoliousesmonthlydata.
MaxWins Maximumconsecutivewinningtradesinarow.

MaxLosers Maximumconsecutivelosingtradesinarow.

PercentProfitable

Numberofwinningtradesdividedbytotalnumberoftrades.
PortfolioValue Valueofa$100,000initialinvestmentafterrunningthesystemfortheperiodoftime.

ProfitFactor Grossprofitdividedbygrossloss.Apositiveprofitfactordenotesanetprofitpertradeonaverage.

SVAPO Vervoortsvolumeandpriceoscillatorisusedtofindexhaustionpointsinthebullregime.

Sharpe Sharperatiomeasurestheriskadjustedperformanceofthesystemusingmonthlydata.Theriskfree
rateofreturnis2%inourcalculations.

TimeinMarket

Thepercentageoftotaltimeinthemarket(eitherlongorshort),whichisnotincludingflatperiods
betweentrades.

Volatility HistoricvolatilitybasedonBlackScholesusingmonthlydataintheportfoliosection.

30

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