MRSwing:

Aquantitativesystemformeanreversionand
swingtradinginmarketregimes


March2010




DavidAbrams ScottWalker
QuantitativeSystemDesigner PortfolioManager
www.daveab.com www.walkertradingpartners.com
dave@daveab.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

demonstratestherobustperformanceofthesystemovertenyears.Finally,MRSwingisincorporated

asacomponentinadiversifiedportfolioofETFs(modeledafteruniversityendowments)andisshownto

significantlyincreasetheportfoliosreturnwhilereducingthemaximumdrawdown.

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

portfoliowithassetclassallocationsinspiredbylargeuniversityendowments:TheIvyPortfolio(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,andcountertrendtrading(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

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

mustbecapableofrobustlyhandlingchangesinmarketvolatility.Forexample,whenwequantifythe

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

systemsareverypronetolossesinasidewaysmarket.Insteadoftryingtoeliminatewhipsawsinthe

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.

2. MeanReversioninEquityIndexes

Themajorequitymarketindicesexhibiteddailyfollowthroughlastcentury,buthavebeenverymuchin

ameanrevertingenvironmentsinceabout2000.Stokesshowed(Stokes06/09/2009and08/10/2009)

howdailyfollowthroughworkedwell1950to2000,butthenitreversed.Wesuggestthatthischange

tomeanreversionisduetotheincreasedspeedatwhichnewsanddataispricedintothemarket.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 Algorithm2:DailyMeanReversion(MR)Rules
if(C>C1)thenbuy if(C>C1)thensellshort

if(C<C1)thensellshort if(C<C1)thenbuy

Theresultsofthesetwosystemsoverthelasttenyearsareshownbelow.

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

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

Asyoucansee,dailymeanreversionhasbeenarespectablesystemoverthelasttenyearswith15.42%

compound annual growth rate (CAGR) and 66% of trades profitable with a reasonable drawdown of

26%.Thechartbelowcomparesthegrowthofa$100,000portfoliotradingthetwosystemsbetween

2000and2010.

 Figure1:DailyMeanReversionvs.DailyFollowThrough
$500,000

$450,000

$400,000

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

$0

DailyFollowThrough DailyMeanReversion

We will delve deeper into meanreversion and identify ways to improve on the base system. The

benchmarkforoursystemisthedailymeanreversionsystembecauseofitssimplicityandperformance

metrics.Thesystemthatwedesignmustimproveonthesimpledailymeanreversionshownabovein

ordertojustifytheaddedcomplexity.

2.1. MeanReversioninMarketRegimes

Wedefinemarketregimesbasedona200daysimplemovingaverage.Wechoosea200daymoving

averagebasedonresearchdoneby(Siegel1998)thatshowedoverthelastcenturya200daymoving

averagefilterwouldhavereducedvolatilityinalongtermstockportfolio.

where N = 200 ,1 , 1 (Algorithm 3)

1 1

Belowshowstheresultsofmeanreversioninbullandbearmarketregimes.

Table3:DailyMeanReversion(MR)inMarketRegimes
$100,000portfoliofrom01/05/1999and02/12/2010

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

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

comparedtobullmarkets.Meanreversionthrivesontheheightenedvolatilityofbearmarkets.

Figure2:MeanReversioninMarketRegimes
$400,000.00

$350,000.00

$300,000.00

$250,000.00

$200,000.00

$150,000.00

$100,000.00

$50,000.00

$0.00

MRinBullRegime MRinBearRegime

TheMRSwingsystemwillbedesignedtotakeadvantageoftheoutperformanceofmeanreversionin

thebearregime,andwewilluseadifferentstrategyinbullregimes.

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.

Oursystem designstarts withthe coreprinciples outlined intheintroduction:(1)weexploitdifferent

characteristicsofmarketsbyusingamarketregimeswitchingmethodtotakeadvantageofshortterm

meanreversioninthebearregime,anddeployswingtradinginthebullregime.Next,wewillemploy

(2) non symmetrical trading algorithms for entries, exits and the regime specific trading algorithms.

Everysystemcomponentmustbebasedon(3)volatilityadaptivemetricssothatitcanhandlechanges

involatilityoveralongtimespan.Finally,werecognizethatnoregimeswitchingmodelwillbeableto

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(Hysteresis2010)isanaturalphenomenonthatappearsinmagnetism,elastics,cellmitosis

and control theory (e.g. thermostats). These systems exhibit path dependence in which the current

statedependsonthepathtakentoachieveit.Thesystemhasmemoryandtheeffectsofthecurrent

inputareonlyfeltafteradelayorrangethresholdisexceeded.Webelievethatmarketsalsoneedtime

torespondtonewinformationand thatresponsedoestakeintoconsiderationrecentmarkethistory.

Our market regime filter requires price to close below the low of the channel before switching into a

bearregime.

Algorithm4:MovingAverageTrendChannel




1, MAX , , ,

, 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).

Thistechniquecapturesthemajormarkettrendswithfewerwhipsawsthanusingthetraditional200

daySMA.Insteadofattemptingtodesignalongtermmarketregimefilterthatremovesallwhipsaws,

werequireeachcomponenttoexhibit(4)robustnesstoregimewhipsawsinthecoretradingalgorithm.

Akeydesigninthealgorithmisnottoexitapositionjustbecausethedominantmarketregimechanged.

Instead,weholdontotheposition,andsimplychangetheentry/exitrulesbasedonthenewregime.

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.

3.2.BearRegime:ShorttermMeanReversion(MR)

Wecanimproveonthedailymeanreversionsysteminsection2byemployinganadaptiveshortterm

meanreversionalgorithm.Somequantitativesystemshaveusedatwoperiodrelativestrengthindex

RSI(2)fordailymeanreversion.AlthoughthiswouldworkfineinMRSwing,wechoosetheDVO(David

VaradiOscillator,2009)becauseitmeetsourprincipleofa(3)volatilityadaptivemetric.ThePercent

Rankfunctionisusedtonormalizethedailydata,andthisnonparametrictechniquerobustlyadaptsto

marketvolatilitychanges.

Algorithm5:GeneralizedDVOandDV2

, ,

1 1

, , , , , ,

5 252

0.5 0.5 0 0 , 0.5 0.5 0 0 0 , 5, 252

TheDavidVaradiOscillator(DVO)wasdesigned(Varadi07/29/2009)tobeashorttermoscillatorusingbarhighs
andlows(maximumsmoothingperiodN=5).TheDV2isonespecificsettingoriginallydesignedfortheSPY(the
weightingperiodwas50/50overthelasttwodays).TheDVOcanbeusedtocreateuniqueweightingschemes
thatfunctionbestforeachclassofsecurityanddefinealocalweightdensity( fortheETForfuturescontract.
Itcapturesdifferentcyclelengths,amplitudes,andreturndistributionsofthesecurity.

TheDVOgivesustheflexibilitytocustomizethesystemtothedifferentcyclelengths,amplitudesand

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.

10

 Figure4:MeanReversion(MR)TradesinBearRegime
UsingDVOonSPYfrom02/2008to08/2008

MRSwingactualtradesontheSPYin2008duringthebearregimetodomeanreversionusingtheDVOwithdefaultsettingsof
theDV2.

3.3.BullRegime:SwingTrading

Therearemanymethodsforswingtradinginbullmarkets.Onesystematicwayofdiscretionaryswing

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.

EldersForceIndex).Thethirdandfinalscreenistoputinatrailingbuystopatthehighsofthebars

untilfilled.Theinitialstoplossisatthelowofthepreviousbar.

11

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

grindingmoveshigher.Thisobservationleadsustochoosinganonsymmetricaltradingalgorithmfor

swingtrading.Entriesuseavolatilityadaptivemetricthatissuitedtofindingfastpullbacks,andexits

use an intermediateterm exhaustion method that includes price and volume. We choose the Value

12

Chart(HelwegandStendahl,2002)forentriesbecauseitdynamicallyidentifiesoverboughtandoversold

levelsevenwhenpricevolatilitychangesovertime.Firstarelativepricechartiscreated,similartoade

trendedpriceoscillator.Then,itisadjustedbyadynamicvolatilityunit.

Algorithm6:ValueChart

| | , | |,




2






0.16, 5

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,soweareonlyusing inthealgorithmtosignalapotentialpullbackentrypoint.

3.3.2.LimitOrderEntryTechnique

MRSwingusesextremepatienceinentriesandexits.Limitordersareusedinswingtradingtoattempt

togetanentryclosetothelowofarecentbar.

Algorithm7:LimitOrderEntries
, ,

Eachbarthelimitordertargetpriceisrecalculatedtodynamicallyadaptto
recentpricechangesandsearchforanentry.MRSwingpatientlywaitsfor
thetargetpriceofthelowestlowofthelasttwobars.

13

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

confirmationofanexhaustionpointlikethetraditionalSVAPOsystem,insteadwestartlookingforan

exitusingourlimitordertechnique(Section3.3.4)whenSVAPOcrossesabovethetopband.

14

3.3.4.LimitOrderExitTechnique

SimilartoentriesMRSwingusesextremepatiencelookingforahighprobabilityexit.Limitordersare

usedinswingtradingtoactivelysearchforanexitclosetothehighofarecentbar.

Algorithm9:LimitOrderExits

, ,

Eachbarthelimitordertargetpriceisrecalculatedtodynamicallyadaptto
recentpricechangesandsearchforanexit.MRSwingpatientlywaitsfor
thetargetpriceofthehighesthighofthelasttwobars.

MRSwingkeepssearchingforalimitorderexitoneachbar.Wealsotestedapplyingatrailingstopset

at the simple moving average of the lows of the last 2 bars. This combined with the limit order exit,

providesabalancedapproachtoexitsthatmosttimeshitthelimitorder,andusesthetrailingstopto

protectprofits.

4. CompositeStrategyandPerformanceResults

Nextwewillcombineeachcomponentofthealgorithmintoanendtoendautomatedtradingstrategy.

Thecomponentswillbetestedinthreedifferentvariations,shownbelow:

Table4:Strategy Rules
Takeallcountertrendtradesinallregimes.Alwaysinthemarket
(longorshort)unlessstoppedoutforthattrade.
MRSwing(counter)
Aggressive BearRegime:golongandshortMRrules
BullRegime:golongandshortswingtraderules

TakeallcountertrendtradesinbearregimeusingMR.Swingtrade
longonlyinbullregime,donotshortabullmarket.
MRSwing(swinglong,MRcounter)
BearRegime:golongandshortMRrules
BullRegime:swingtradeloneonly(nevershort)

Conservativesystemthatonlytradesinthedirectionofthedominant
marketregime.Nevercountertrendtrade.
MRSwing(nocounter)
Conservative BearRegime:sellshortusingMRrules(neverlong)
BullRegime:golongswingtrades(nevershort)

15

Wecompareanaggressivesystemthattakesallcountertrendtradesinbothbullandbearregimes.A

countertrendtradeintheswingtradingsystemissimplytosellshortinsteadofexitingwhenthelimit

orderpriceisfilled(Section3.3.4).ThenexttableshowstheperformanceofMRSwingontheSPY,an

ETFthatfollowstheStandardandPoors500IndexoflargecapitalizationUSstocks.

Table5:MRSwingonSPY
$100,000portfoliofrom02/01/2000to02/12/2010

System CAGR CAGR Sharpe Portfolio Timein Max Max Profit Percent Max
riskadj Value Market Wins Losers Factor Profitable DD
MRSwing 37.90% 38.34% 1.58 $2,484,277 98.81% 17 6 2.81 69.47% 23.65%
(counter)

MRSwing 35.16% 51.25% 1.54 $2,068,616 72.79% 17 6 2.75 69.43% 21.68%
(swinglong,
MRcounter)
MRSwing 23.07% 54.06% 1.37 $801,735 48.01% 15 3 3.25 74.23% 13.09%
(nocounter)

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

16

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.

Theconservativesystemshowsmuchlowerdrawdown,butbetween2004and2006performancewas

flat. The system compounds portfolio equity by reinvesting profits, which accelerated 2008 and 2009

returns.

Figure6:MRSwing SPY

$3,200,000

$1,600,000

$800,000

$400,000

$200,000

$100,000

MRSwing(counter)37.90%CAGR
MRSwing(swinglong,MRcounter)35.15%CAGR
MRSwing(nocounter)23.07%CAGR

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5. MRSwing:ExchangeTradedFunds(ETFs)

MRSwingwasoriginallydevelopedfortheSPY.WetestedtheoutofsampleresultsonotherETFsand

foundarobustsystemperformanceacrossdifferentgeographicalandmarketsizeindexbasedETFs.

Table6:MRSwing(counter)ExchangeTradedFunds07/2000to02/2010

Sym CAGR CAGR Sharpe Portfolio Max Max Profit Percent MaxDD
riskadj Value Wins Losers Factor Profitable
Emerging EEM 24.76% 25.18% 0.69 $365,399 10 4 1.46 64.46% 37.63%
Markets
Russell2000 IWM 14.60% 14.69% 0.60 $322,973 13 4 1.61 65.89% 45.07%
SmallCaps
Nasdaq100 QQQQ 36.88% 37.27% 1.12 $2,083,961 10 5 1.74 67.23% 23.16%
LargeCap
Vanguard VTI 28.56% 28.95% 1.33 $697,403 10 6 2.05 65.51% 19.93%
TotalMarket

Nextweconsidertheconservativeversionthattakesnocountertrendtrades.

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

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

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

Nasdaq100 QQQQ 29.25% 66.90% 1.28 $1,196,429 9 4 2.29 72.28% 15.93%
LargeCap
Vanguard VTI 16.40% 34.84% 1.07 $323,548 8 4 2.27 66.43% 13.57%
TotalStock
Market

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.

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6. MRSwing:ManagedFutures

WetestedMRSwingonoutofsampledataonthe@ESand@NQfuturescontracts.Futuresprovide

the benefits of excellent liquidity, low cost commissions, flexible use of leverage, and tax advantages

overETFs(e.g.marktomarketresults60%longtermcapitalgainsand40%shortterm).Oneimportant

differenceintradingfuturesisourlimitordersforentriesandexitsmaygetfilledinovernighttrading.

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.

Thatmeansthesystemstartstrading 2contractsand4contractsrespectively.Thefixed ratiomoney

managementsystemtradesaggressivelyforasmallaccountthengetsmoreconservativeastheaccount

sizegrows.Forexample,$10,000getsonecontract.Thenitneeds20Kforthenextcontract.At30Kit

istrading2contracts,andneeds30Kmoreinprofitforthethirdcontract,etc.

Table8:MRSwing(counter)$100,000portfoliofrom07/19/2000to02/22/2010

Sym Money CAGR CAGRrisk Sharpe Portfolio Max Max Profit Percent MaxDD
Mgt adj Value Wins Losers Factor Profitable
ES Fixed 34.76% 35.41% 1.14 $1,839,589 14 4 2.56 67.75% 46.43%
Ratio
ES FF 28.96% 29.49% 1.26 $1,197,509 14 4 3.18 67.75% 22.24%
50K/ctr
ES FF 70.12% 71.59% 1.28 $17,892,862 14 4 4.60 67.75% 46.59%
25K/ctr
NQ Fixed 28.01% 28.26% 0.89 $1,091,448 9 4 1.68 68.41% 33.84%
Ratio
NQ FF 19.90% 20.07% 0.95 $579,387 9 4 1.72 68.41% 21.37%
50K/ctr
NQ FF 43.26% 43.66% 0.98 $3,243,852 9 4 1.74 68.41% 42.09%
25K/ctr

The aggressive version of MR Swing on the ES and NQ contracts with fixed fractional and fixed ration

moneymanagementisshownbelow.Weincluded$2.30percontractforcommissions.

19

 Figure7:MRSwing(counter)ManagedFutures
withDifferentMoneyManagement

$3,200,000

$1,600,000

$800,000

$400,000

$200,000

$100,000

$50,000
Jul00
Dec00
May01
Oct01
Mar02
Aug02
Jan03
Jun03
Nov03
Apr04
Sep04
Feb05
Jul05
Dec05
May06
Oct06
Mar07
Aug07
Jan08
Jun08
Nov08
Apr09
Sep09
Feb10
NQ50K/contract NQ25K/contract NQFixedRatio
ES50K/contract ESFixedRatio

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 3rd contract. The 25K/contract system more quickly adds contracts.

Noticein thechartbelow the growthofthe25K/contractsystem,compounding70%peryearturnsa

$100,000 portfolio into $17.8M over ten years. We leave this as an option for the aggressive traders

interestedinMRSwing.

20

 Figure8:MRSwing(counter)ManagedFuturesES
withFixedFractional$25,000/contract

$25,600,000

$12,800,000

$6,400,000

$3,200,000

$1,600,000

$800,000

$400,000

$200,000

$100,000

$50,000

MRSwing(counter)ES25K/contract

Inthenextsection,wewillshowhowMRSwingcanbeusedtomakeamuchmoreconservativesystem

thatstillgivessolidreturns.

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

Sym Money CAGR CAGRrisk Sharpe Portfolio Max Max Profit Percent MaxDD
Mgt adj Value Wins Losers Factor Profitable
ES Fixed 26.66% 57.22% 1.21 $1,004,598 18 4 3.03 70.59% 23.20%
Ratio
ES FF 18.52% 38.45% 1.11 $525,439 18 4 3.50 70.59% 10.71%
50K/ctr
ES FF 45.65% 105.41% 1.23 $3,927,298 18 4 4.48 70.59% 21.86%
25K/ctr
NQ Fixed 24.46% 50.61% 0.98 $831,042 11 4 2.44 74.77% 29.06%
Ratio
NQ FF 16.41% 32.89% 1.04 $435,128 11 4 2.51 74.77% 16.38%
50K/ctr
NQ FF 37.45% 81.38% 1.12 $2,173,202 11 4 2.57 74.77% 34.23%
25K/ctr

21

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

theconservativesystem,25K/contract,wedoubleourmaxdrawdown,andgetevenmorethan2Xthe

performance(45.65%CAGRforES,37.45%CAGRforNQ).

Figure9:MRSwing(nocounter)ManagedFutures
withDifferentMoneyManagement

$3,200,000

$800,000

$200,000

$50,000
Oct01

Aug02

Oct06

Aug07
Dec00
May01

Mar02

Jan03
Jun03
Nov03
Apr04
Sep04
Feb05

Dec05
May06

Mar07

Jan08
Jun08
Nov08
Apr09
Sep09
Feb10
Jul00

Jul05

NQ50K/contract NQ25K/contract NQFixedRatio

ES50K/contract ES25K/contract ESFixedRatio

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

22

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

combiningandemployingasetofnoncorrelatedstrategiesachievessubstantialimprovedreturnsand

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

InordertocomparetheIvyPortfoliowithtimingtoMRSwing andablendedapproach,wefirstalign

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.

23

 Table10:IvyPortfolioInstruments

1. Vanguard500IndexInvestor(VFINX)
2. VanguardTotalInternationalStockIndex(VGTSX)
3. ThomsonReuters/JefferiesCRBIndex,acommoditypriceindex1
4. VanguardREITIndex(VGSIX)
2
5. VanguardIntermediateTermBondIndex(VBIIX)

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:

Theassetsportionoftheportfolioisfullyinvestedintheassetwhentheclosingpriceisabovethe10

monthmovingaverage;itgoestocashwhenitisbelow.Cashismodeledatthe30dayTBillaverageof

approximately2.2%andweincludenormalcommissionsforadirectaccessbroker($.005/share).

TheIvyPortfoliodiversificationaddssignificantvaluevs.abuyandholdoftheS&P500inbothreturn

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.

24

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.

Table14:CrossCorrelationofIvyPortfolioComponentsandMRSwingFutures

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

MR Swing trading the Futures with ES and NQ work well together since they respond differently to

marketmoves,withtheSharpe,maximumdrawdownandvolatilityallimprovingonthecombinedbasis.

Table13:CombingFuturesMRSwing(nocounter)FixedRatio
8/1/2000to1/28/20105
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.

25

 Figure10:IvyPortfolio+MRSwing

MRSwing
@ES
Bonds(VBIIX)
10%
16% MRSwing
@NQ
10%

RealEstate(VGSIX)
16% DomesticStocks
(VFINX)
16%

Commodities(CRB)
16% InternationalStocks
(VGTSX)
16%

Werebalancebacktothe10%allocationtoESandNQatthebeginningofeachyear.Includinga1/5th

allocationtoMRSwingintothecombinedportfoliodrivesanimpressiveincreaseof5.5pointsofCAGR,

0.7Sharpe,cutsthedrawdownby3/5th,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

26

 Figure11:IvyPortfoliow/Timingvs.CombinedIvyMRSwing

$400,000

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

$0
Aug00
Nov00
Mar01
Jul01
Nov01
Mar02
Jul02
Nov02
Mar03
Jul03
Nov03
Mar04
Jul04
Nov04
Mar05
Jul05
Nov05
Mar06
Jul06
Nov06
Mar07
Jul07
Nov07
Mar08
Jul08
Nov08
Mar09
Jul09
Nov09
RebalIvy+NQ+ES
Ivyw/Timing

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.

27

8. Conclusion

MR Swing is a quantitative system that employs daily meanreversion and swing trading in different

marketregimes.Overthelasttenyears,itshowedarobustequitycurve(37.90%CAGR,1.58Sharpe,

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.

Thesystemisbasedonfourcoreprinciples:(1)amarketregimeswitchingmethodtoexploitdifferent

characteristics of markets by using shortterm meanreversion in the bear regime, and deploy swing

tradinginthebullregime.Next,ituses(2)nonsymmetricaltradingalgorithmsforentries,exitsandthe

regimespecifictradingalgorithms.Everysystemcomponentisbasedon(3)volatilityadaptivemetrics

thatitcanhandlechangesinvolatilityoveralongtimespan.Finally,sincenoregimeswitchingmodel

willbeabletoeliminateallfalsesignals,eachcoresystemcomponentexhibits(4)robustnesstoregime

whipsaws.

Finally,weincludedMRSwingasa20%componentintoadiversifiedportfoliooflowcorrelationETFs

basedontheIvyPortfolio,modeledafteruniversityendowments.MRSwingincreasedthecombined

portfolioCAGRbyafactorof1.5whilereducingthemaxdrawdowntoonly4%.Thisdemonstratesthat

investorswillbenefit byincludingaportionoftheirfunds toa noncorrelatedsystematic approach to

smoothandprotecttheirportfolioperformance.

28

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

usedtogeneratethetradecharts.AmiBrokerwasusedtosimulatetheIvyPortfoliofromYahoodata

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.

29

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30