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WhitePaperTrModelFeb2012

WhitePaperTrModelFeb2012

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Published by michaelarold
Discussing the method behind Covestor's "Technical Swing" trading model
Discussing the method behind Covestor's "Technical Swing" trading model

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Published by: michaelarold on Mar 22, 2012
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11/15/2012

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Combining Momentum and Mean Reversionin a Short-term Trading Model
 A White Paper by Michael Arold
February 2012
 
White Paper Combining Momentum and Mean Reversion in a Short-term Trading Model
introduction
Are stock prices predictable? Proponents ofthe efficient market hypothesis (EMH) believethey are not. According to the theory, pricesalways reflect all available fundamentalinformation. Since future news cannot bepredicted, asset price changes are impossible toforecast as well. However various marketanomalies have been observed by academicsand have challenged EMH. Obvious examplesare asset price bubbles and crashes, whichseriously question EMH, French (1988). It seemswidely accepted that markets are at least not fully,but mostly efficient.
Two inefficiencies are momentum and meanreversion. Both are the foundation of thequantitative Technical Swing trading model, whichis available oncovestor.comand are also appliedby various hedge funds, who focus on statisticalarbitrage strategies.
I will first introduce both inefficiencies andthen discuss practical aspects of the tradingapproach.
momentum
Momentum in terms of securities tradingrefers to the technical expression: once a body isput in motion, it keeps moving as long as no newforces are applied. The same can happen tosecurities under certain conditions. TheEconomist (2011) described the momentum effectin a recent issue: "Sincethe 1980s academicstudies have repeatedlyshown that, on average,shares that haveperformed well in thepast continue to do so forsome time. The effect isone of the strongest market anomalies known byanalysts." Jegadeesh (1993) was one of the first,who documented its persistence and foundabnormal returns of momentum-based strategieswhile looking at data from 1965 until 1989. In fact,even recent literature reports significantoutperformance when assets showed relativestrength in the prior 3 to 12 months.
Fig 1: 
Whole Foods Markets, Inc. (NASDAQ: WFM): a typical momentum stock, which has outperformed the S&P 500 since 2009.
It seems still controversial why themomentum phenomenon exists. The researchfield of Behavioral Finance is trying to explainmomentum as well as the mean reversionanomaly by analyzing psychological factors of thecrowd. However, the underlying reasons areirrelevant from a practitioner's point of view.
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Momentum
:
If it went up in thepast, there is anincreased probabilitythat it will keep goingup in the future.
 
White Paper Combining Momentum and Mean Reversion in a Short-term Trading Model
mean reversion
Mean reversion refers to investor’s tendencyto overreact to new market information andtherefore create prices, which are either too lowor too high with respect to underlying securityvalue. Assets then revert to the mean price of acertain period.
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 carriedout to characterize the short-term nature of theeffect. Antweiler and Frank (2006) concluded that“overreaction to news is the typical pattern on themain American stock markets between 1973 and2001”. The authors observed timeframes of up to30 days after the news event. Others, such asLehmann (1988) also found "sharp evidence ofmarket inefficiency in the form of systematictendencies for current 'winners' and 'losers' in oneweek to experiencesizable return reversalsover the subsequentweek in a way thatreflect apparentarbitrage profits".
If there is indeed asignificant mean reverting effect in certain assetprices, it would be possible to trade against thenews, sell into market rallies and produceabnormal returns. However, research is quitecontroversial on the strength of the effect. CXOAdvisory Group (2011) for example investigatedmean reversion characteristics of a major indexand could find “only a weak reversion over shortintervals”. It seems like the anomaly is moreevident on an individual security than on an indexlevel and in general weaker than the momentumeffect.
combining both effects
Both strategies have their advantages andchallenges when applied in a clear-cut fashion:momentum-based investing requires certainmarket environments and can produce significantportfolio drawdowns when momentum stocks fallout of favor. Mean reversion type trading on theother hand can create nice steady returns, butcan also suffer from so called black swan risks:since these strategies often prohibit the use ofstop levels, a single non-mean reverting eventcan seriously damage performance. A solutioncan be to combine both approaches.
Conceptually, the combination is fairly simplesince both anomalies act on different time frames:the strategy is to trade mean reverting moves ofsecurities, which have shown certain momentumcharacteristics. In other words, momentumdefines stock selection, mean-reversion definesentries and exits.
In the past, trading costs had been prohibitiveof short-term trading strategies for most individualinvestors. With the rise of direct access brokersand their ultra-low commissions in recent years,mean reversion trading has become feasible froma cost standpoint.
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Mean reversion
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Investors tend tooverdo it during theirbuying frenzies orselling panics.

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