Long-Term Trend Following & Short-Term Mean Reversion Systems

trading systems

trading systemsIt has been about three months since we started this simple system experiment and none of the systems have really made a whole lot of progress.

While none of the systems have outperformed a traditional buy and hold approach to this point, there have been a few interesting developments. The systems that have performed as well as buy and hold are almost all long term trend following systems. The one exception is the short term mean reversion system. The short term trend following approaches have all underperformed the general market benchmark.

What does this mean? Well, nothing. It’s still WAY too small of a sample size to carry any significance whatsoever. However, it does suggest that if we wanted to trade a trend following system, we should go with a long term version. It also suggests that if we wanted to trade a short-term system, we should take a look at mean reversion systems.

This is not a major revelation. It is right in line with what we expected coming into this experiment. It will be interesting to see if this continues to hold true in the midst of a major market decline. If it does persist, we might be able to develop a hybrid system that combines a long-term trend following approach with a short-term mean reversion component.

Comparing Our Systems

If you would have looked at the overall performance of all of these systems on Wednesday, you would have thought that System 2B had everything figured out as it was looking mighty smart sitting in cash. However, as the market bounced back on Thursday and Friday, System 2B was stuck on the sideline watching.

The systems that made the most headway this week were the ones that had the long term outlook necessary to sit through all of the turmoil of the week without flinching. Those systems were rewarded by still holding long positions when they finally made it to Thursday and Friday.

On the other hand, the systems that flinched either switched to cash or short positions at what turned out to be the lows of the week. The systems that went to cash took the losses early in the week and missed out on the rally. The systems that went short took it even worse and ended up losing money all week long.

While there are a number of long-term systems that have matched the performance of a buy and hold approach thus far, not one single system has outperformed that approach. Of course, that is likely to change given a significant market downturn.

System 1 – Buy & Hold

Overall Return: +1.27%

Last Week: +0.44%

mean reversion systemsSystem 1 investors were taken on a wild ride this week as the market appeared to be completely collapsing on Monday, Tuesday and Wednesday. That all changed when things bounced back on Thursday and Friday. The end result was that investors saw their overall return jump from 0.44% to 1.27% over the course of the week. Of course, this required them to sit through a pretty ugly situation earlier in the week.

As we say every week, System 1 investors simply take what the market provides regardless of whether it is positive or negative. They just hope that it will continue to be net profitable over the long haul and that they won’t be caught in the middle of any significant downtrends when they eventually need their capital. System 1 offers no protection on the downside. It simply takes what the maker provides.

System 2 – IBD Market Calls

Overall Return: A: -3.27%, B: +0.62%, C: -8.12%, D: -3.98%

Last Week: A: -1.36%, B: +0.62%, C: -3.56%, D: -1.21%

Here is a quick reminder about the different versions of System 2:

  • System 2A – Long on Confirmed Uptrend, Cash on Market In Correction
  • System 2B – Long on Confirmed Uptrend, Cash on Uptrend Under Pressure
  • System 2C – Long on Confirmed Uptrend, Short on Market In Correction
  • System 2D – Long on Confirmed Uptrend, Cash on Uptrend Under Pressure, Short on Market In Correction

mean reversion systemsThis week did a fantastic job of demonstrating all of the flaws that can sabotage System 2. After Tuesday’s big losses, IBD switched their market outlook to Market in Correction. Then, following Thursday’s strong action, they slide their outlook back to Uptrend Under Pressure. These changes forced Systems 2A and 2C out of their long positions at the bottom of the week’s range. They also signaled short positions for Systems 2C and 2D at the worst possible time.

Once again, we are seeing the versions of this system with short components getting trapped in those short trades. This could become irrelevant if the market falls off again in the coming week, but it appears that the line of least resistance is upward for now.

For the coming week, Systems 2A and 2B are sitting in cash positions. Systems 2C and 2D are holding short positions. The only way this will change is if IBD changes their current outlook to Confirmed Uptrend. This would likely require a Follow-Through Day, which is a significant up day on increased volume.

The returns that have been recorded by System 2 so far seem to indicate that this system will not be profitable. However, this could just be the result of a very small, and poorly timed sample size.

System 3 – 10/100 Moving Average Crossover System

Overall Return: +1.27%

Last Week: +0.43%

mean reversion systemsThis roller coaster week was especially noticeable for System 3 traders. Tuesday’s losses took the SPY all the way down to its 100-day line. Then, it lost that line intraday on Wednesday and closed just slightly above it. Thursday and Friday told a completely different story as the price jumped back above the 10-day line and ended up closing out the week well above both averages.

This was the second time the SPY tested its 100-day line since we began trading these systems in mid-July. After the ETF bounced off of its 100-day line in September, it went on to rally to new highs. The bounce appears to be even stronger this time, but that could easily change on Monday.

In order to get out of System 3’s current long position, the 10-day line would have to cross below the 100-day line. For that to happen, the price will need to trade below the 100-day line. We have yet to see it close below that line even once, so for now System 3 appears to be sitting tight. This position is in line with the long-term trend and seems to be the path of least resistance.

System 4 – 89/13 Breakout System

Overall Return: -5.98%

Last Week: -4.14%

mean reversion systemsSystem 4 suffered similar results to System 2A this week. It came into the week holding a long position, but was stopped out at Wednesday’s close after the SPY closed below its 13-day low on Tuesday. It was then stuck in cash as the market rallied back on Thursday and Friday.

While it might seem unlucky the way this played out, we need to remember that we didn’t know Thursday and Friday were going to happen on Tuesday or Wednesday. After Tuesday’s action, it felt like the market was going to head straight down for months without even a small rally. Obviously that wouldn’t happen, but the point is that we had no idea what to expect. That is why we had to follow the rules and sell out at what appears to be a short term bottom.

Moving forward, System 4 is sitting in cash and looking for a new 89-day high or low to signal an entry. With the price currently sitting at 170.26, it is probably more likely that the 89-day high of 172.76 is hit first. The market is still a long way from a new 89-day low of 154.97. Once again, we have no business predicting either outcome. Our job is simply to sit and watch and then react when we get a signal.

System 5 – 3 Day High/Low Mean Reversion System

Overall Return: +1.22%

Last Week: +0.58%

mean reversion systemsWhile all of the other Systems seemed to get unlucky this week, System 5 seems like it benefited from the week’s action. It came into the week looking for three down closes in a row because of the big up day last Friday. After big down days on Monday and Tuesday, Wednesday was technically an up day, so that means no go for System 5, right?

I actually had to look up the original system rules in order to make sure I got this right. System 5 isn’t concerned with whether the prices closes up or down. It simply cares that the chart shows lower highs and lower lows for three days in a row. That means that Wednesday’s crazy action did qualify as an entry signal.

The next issue came from Thursday’s action. After Wednesday’s entry signal, System 5 had to enter a long position at Thursday’s close. However, Thursday’s close was also an exit signal because the price closed above the 5-day moving average. This meant that the system entered the position knowing that is was going to exit on the following close.

While this particular trade was a bit confusing, and I’m not sure if I got it technically right, it did work out well for System 5. Entering on Thursday’s close and exiting on Friday’s close resulted in a nice, quick profit for the system. Looking ahead to next week, we are in the same position we were in a week ago. Three down days in a row will signal us to jump back in.

System 6 – Simple Moving Average Systems

Overall Return: A: +1.27%, B: +1.27%, C: -4.96%, D: +1.27%, E: +1.27%, F: -10.92%

Last Week: A: +0.44%, B: +0.44%, C: -3.10%, D: +0.44%, E: +0.44%, F: -6.57%

Here is a quick reminder about the different versions of System 6:

  • System 6A – Long above 200 day SMA, Cash below 200 day SMA
  • System 6B – Long above 100 day SMA, Cash below 100 day SMA
  • System 6C – Long above 50 day SMA, Cash below 50 day SMA
  • System 6D – Long above 200 day SMA, Short below 200 day SMA
  • System 6E – Long above 100 day SMA, Short below 100 day SMA
  • System 6F – Long above 50 day SMA, Short below 50 day SMA

mean reversion systemsEach of the six versions of System 6 came into the week holding long positions. When the SPY lost its 50-day line on Tuesday, that signaled versions 6C and 6F to exit those long positions at Wednesday’s close. That also signaled for System 6F to go short at Wednesday’s close. Once again, we see the 50 day system change its positions at the absolute worst possible time.

The price got close to the 100-day line, but never closed below it. That means that the 100-day and 200-day versions of System 6 all stayed the course with their long positions and were rewarded for it on Thursday and Friday. System 6C was stuck in cash until Thursday’s action signaled it to re-enter at Friday’s close. System 6F took it even worse by being trapped in a short position Thursday and Friday. That means it lost money both ways over the week.

In the coming week, each of these systems are back in long positions, but for the damage is already done for the shorter term versions. The 50-day line continues to signal exits right before the market posts big up days. Trading this system with real money would have been extremely aggravating over the past few months.

On the flip side, the longer term systems have yet to signal a single trade and have been rewarded for this by being among the only systems to match the performance of the buy and hold approach so far. Obviously, that will change once the market experiences a significant drawdown, which is bound to happen eventually.