Combining Momentum and Mean Reversion in a Short-term Trading Model

A White Paper by Michael Arold February 2012

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Combining Momentum and Mean Reversion in a Short-term Trading Model one of the strongest market anomalies known by analysts." Jegadeesh (1993) was one of the first, who documented its persistence and found abnormal returns of momentum-based strategies while looking at data from 1965 until 1989. In fact, even recent literature reports significant outperformance when assets showed relative strength in the prior 3 to 12 months.

introduction
Are stock prices predictable? Proponents of the efcient market hypothesis (EMH) believe they are not. According to the theory, prices always reect all available fundamental information. Since future news cannot be predicted, asset price changes are impossible to forecast as well. However various market anomalies have been observed by academics and have challenged EMH. Obvious examples are asset price bubbles and crashes, which seriously question EMH, French (1988). It seems widely accepted that markets are at least not fully, but mostly efcient. Two inefficiencies are momentum and mean reversion. Both are the foundation of the quantitative Technical Swing trading model, which is available on covestor.com and are also applied by various hedge funds, who focus on statistical arbitrage strategies. I will first introduce both inefficiencies and then discuss practical aspects of the trading approach.

Fig 1: Whole Foods Markets, Inc. (NASDAQ: WFM): a typical momentum stock, which has outperformed the S&P 500 since 2009.

momentum
Momentum in terms of securities trading refers to the technical expression: once a body is put in motion, it keeps moving as long as no new forces are applied. The same can happen to securities under certain conditions. The Economist (2011) described the momentum effect in a recent issue: "Since the 1980s academic Momentum: studies have repeatedly If it went up in the shown that, on average, past, there is an shares that have increased probability performed well in the that it will keep going

It seems still controversial why the momentum phenomenon exists. The research field of Behavioral Finance is trying to explain momentum as well as the mean reversion anomaly by analyzing psychological factors of the crowd. However, the underlying reasons are irrelevant from a practitioner's point of view.

up in the future.

past continue to do so for some time. The effect is

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Combining Momentum and Mean Reversion in a Short-term Trading Model signicant mean reverting effect in certain asset prices, it would be possible to trade against the news, sell into market rallies and produce abnormal returns. However, research is quite controversial on the strength of the effect. CXO Advisory Group (2011) for example investigated mean reversion characteristics of a major index and could nd only a weak reversion over short intervals. It seems like the anomaly is more evident on an individual security than on an index level and in general weaker than the momentum effect.

mean reversion
Mean reversion refers to investors tendency to overreact to new market information and therefore create prices, which are either too low or too high with respect to underlying security value. Assets then revert to the mean price of a certain period.

combining both effects

Both strategies have their advantages and challenges when applied in a clear-cut fashion: momentum-based investing requires certain market environments and can produce significant portfolio drawdowns when momentum stocks fall out of favor. Mean reversion type trading on the other hand can create nice steady returns, but can also suffer from so called black swan risks: since these strategies often prohibit the use of stop levels, a single non-mean reverting event can seriously damage performance. A solution can be to combine both approaches. Conceptually, the combination is fairly simple since both anomalies act on different time frames: the strategy is to trade mean reverting moves of securities, which have shown certain momentum characteristics. In other words, momentum defines stock selection, mean-reversion defines entries and exits. In the past, trading costs had been prohibitive of short-term trading strategies for most individual investors. With the rise of direct access brokers and their ultra-low commissions in recent years, mean reversion trading has become feasible from a cost standpoint.

Fig 2: Even though WFM is showing momentum characteristics, investors also overreacted at certain times and the stock "reverted to the mean".

A good amount of research has been carried out to characterize the short-term nature of the effect. Antweiler and Frank (2006) concluded that overreaction to news is the typical pattern on the main American stock markets between 1973 and 2001. The authors observed timeframes of up to 30 days after the news event. Others, such as Lehmann (1988) also found "sharp evidence of market inefciency in the form of systematic tendencies for current 'winners' and 'losers' in one week to experience sizable return reversals over the subsequent Mean reversion: Investors tend to week in a way that overdo it during their reect apparent

buying frenzies or selling panics.

arbitrage prots". If there is indeed a

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Combining Momentum and Mean Reversion in a Short-term Trading Model for the trade. I'm trying to find opportunities with a minimum potential risk/reward of 2.

stock selection
Various methods can be applied to identify momentum assets. My focus is on S&P 500 stocks because of liquidity needs. stockcharts.com is ranking index members according to their technical strength and assigns values between 0 and 100 (SCTR, "Stockcharts Technical Rank"). Stocks, which have ranked high on this list for at least three months or have recently demonstrated improving strength are put on my main watch list. This step is repeated weekly. The opposite process is performed in weak markets, where declining stocks are sold short. Another method is to run proprietary technical scans to uncover stocks, which have demonstrated superior relative strength over the last three months. The final watch list usually contains around 100 stocks.

quantifying the edge

What is the statistical advantage of the proposed Momentum/Mean Reversion strategy? Since markets are mostly efficient, this "edge" is expected to be fairly small. Henry Carstens, an experienced quantitative trader, formulated an "axiom of the small edge": "a trader's long run edge is smaller than he thinks; it is much more akin to a card-counting blackjack player's edge of 1% due to variance, ever-changing cycles, and fear-induced losses." The conclusions from the axiom don't have to be negative. It is still possible to outperform the markets with a small edge if this statistical advantage is repeated many times and good money management is applied. Some statistics of the Technical Swing trading model illustrate how the axiom of the small edge is working in practice. Table 1 summarize 2011 results and illustrates the nature of the strategy. HMMR Strategy Statistics 2011 Portfolio return # of traded positions % winning trades Normalized avg. win Normalized avg. loss Avg. holding period winners Avg. holding period loosers 14.6% 322 49.07% 0.49% -0.36% 10 days 4 days

mean reverting trade

Stocks on the watch list are monitored daily in order to identify mean reverting trades. Signal to action is an orderly pullback to the rising 20-day moving average, among other factors. Zones of investor's overreaction are identified using a channel technique and positions are either closed or sizes reduced. A channel is a graphical tool, which indicates zones where prices have recently pulled back and is constructed by adjusting the 20-day moving average by a certain percentage above and below mean. One of the goals is to take losses quickly when the mean reverting trade does not work out as expected. Positions will be closed at predefined stop points, which have a chance to act as natural support areas. Of course, a potential move to the upper channel boundary should result in higher gains than a drop to the loss point, thus creating a positive expected risk/reward ratio

Table 1: 2011 Model statistics illustrates the "law of the small edge"

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Combining Momentum and Mean Reversion in a Short-term Trading Model dominate daily price action, momentum and mean reversion effects can be the foundation of profitable short-term trading models. Of course, markets can always change and these effects could dissipate when many investors start to exploit them. However, since their foundation lies in the psychologic behavior of the crowd, I believe that investors would need to eliminate greed and fear when investing, which seems unlikely.

Overall, the strategy generated a positive return of 14.6%, while the S&P 500 traded flat in 2011. 322 trades were taken throughout the year. This number seems high, but it is in fact typical for statistical arbitrage strategies. Key of the strategy was that the average win was higher than the average loss. I am using numbers, which are normalized by account size in order to eliminate the effect of volatility differences of different stocks. The average win of 0.49% means that the account gained almost half a percent with each of these trades. The average normalized loss was only slightly smaller: 0.36%. Despite the small difference, the model significantly outperformed its benchmark. This is the axiom of the small edge at work. The table also shows average holding periods. For a traditional investor or mutual fund, holding periods of four to ten days seem ridiculously small. They are fine for the quantitative trader as long as the statistical advantage exists on this time frame. Longer term results have been similar: since inception in September 2007, the strategy returned 70.1% while the index lost 7.8% during the same period. Within four years, over 1000 positions were traded, which is a large enough sample size to conclude that the discussed market anomalies are present, especially since the model was traded during entirely different market phases: short positions dominated in the bear market until 2009, stocks were mostly held long during the following bull phase.

conclusion
Presented trading results support the conclusion that certain market anomalies could be exploited to achieve abnormal returns in the period from 2007 to 2012. Even though the effects are small and noise and random behavior

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Combining Momentum and Mean Reversion in a Short-term Trading Model

references
The Economist, 6. Jan 2011: Momentum in Financial Markets http://www.economist.com/node/17848665

disclaimer
All information in this paper is for educational purpose only. Consult with your professional investment advisor before making any investment decisions based on information of this document.

French, 1988: Crash Testing the Efcient Market Hypothesis. Published in NBER Macroeconomics Annual 1988, Volume 3 http://www.nber.org/chapters/c10957 Jegadeesh, Titmann, 1993: Returns to Buying Winners and Selling Losers: Implications for Stock Market Efciency. Published in Journal of Finance, Volume 48, Issue 1, March 1993 Antweiler, Frank, 2006: Do Stock Markets Typically Overreact to Corporate News Stories http://papers.ssrn.com/sol3/papers.cfm? abstract_id=878091 Lehman, 1988: Fads, Martingales and Market Efciency, Working Paper http://www.nber.org/papers/w2533.pdf CXO Advisory Group, 2011, a Slinky Short-term reversion effect http://www.cxoadvisory.com/3718/volatility-effects/ a-slinky-short-term-reversion-effect/ Henry Carstens, 2011, Axiom of the Small Edge http://www.verticalsolutions.com/notes/ small_edge.html

about the author

Michael Arold is a private investor and Covestor Model Manager with a degree in aerospace engineering from the University of Stuttgart in Germany. Contact him at michaelarold@gmail.com

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