How a mean reversion strategy performed in August - forex trading system blog

How a mean reversion strategy performed in August ~ forex trading system blog

Prof. Andrew Lo and Mr. Amir Khandani at MIT recently wrote a paper on "What Happened To The Quants In August 2007?" (Hat tip to my reader Mr. J. Rigg for the article). Most of their conclusions confirm what many observers already suspected: that the loss is likely due to the simultaneous forced liquidation of portfolios holding similar positions by various quantitative funds. What is noteworthy, however, is that they constructed a mean-reversion strategy and observed what happened to it during August. This strategy is very simple: buy the stocks with the worst previous 1-day returns, and short the ones with the best previous 1-day returns. Despite its utter simplicity, this strategy has had great performance since 1995, ignoring transaction costs. The Sharpe ratio was an astounding 53.87 in 1995, gradually decreasing to 4.47 in 2006. However, the strategy also had a disastrous few days on August 7-9, suffering a cumulative (arithmetic) return of -6.85% in those 3 days. Then on August 10, it rebounded, like the rest of the quant funds, with a return of 5.92%, almost reversing all of its previous losses. For me, this experiment reveals three interesting points: 1) a simple price factor seems to capture most of the performance of the complex factor models run by the gigantic hedge funds; 2) even technical mean-reverting factors suffer losses, not just momentum (growth) factors based on fundamentals; and 3) if one wants to avoid disasters and enjoy spectacular returns, even a one-day holding period is too long. I havent done the experiment myself yet, but I bet that if we were to liquidate the portfolio at market close each day, not only would we avoid the loss of -6.85% in those 3 days, but would probably end up with a positive return of a similar magnitude!
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The enduring profitability of mean reversion strategies - forex trading system without indicators

The enduring profitability of mean reversion strategies ~ forex trading system without indicators

Some readers have doubts about my assertion that mean-reversal models continue to be very profitable during this whole year of financial and economic disasters. So I backtested the mean-reversion strategy in Example 3.8 of my book with the most recent one-year SP1500 data. Without transaction cost, the Sharpe ratio is 4.8. Even after subtracting 10 b.p. round-trip transaction cost, it is still at 3.5.

Since the strategy was constructed over a year ago while I was writing the book, this most recent backtest is done on unseen data, with absolutely no look-ahead bias!
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Mean reversion is getting stronger - forex trading systems reviews

Mean reversion is getting stronger ~ forex trading systems reviews

As I mentioned in various previous blog posts, (e.g. see here), I believe mean-reversion strategies have been performing very well in the last year. Now here is an article (hat tip: Laurence) that provides concrete analysis to support this hypothesis. In fact, the author points out that most of the mean-reversion in recent years comes from the overnight close-to-open reversal.
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A combination momentum and mean reversal model based on earnings annoucements - forex android trading system

A combination momentum and mean reversal model based on earnings annoucements ~ forex android trading system

Mark Hulbert of the New York Times just discussed 2 momentum strategies investigated by professors David Aboody, Brett Trueman and Reuven Lehavy.

Strategy A: pick stocks in the top percentile of 12-month returns. Buy them (individually) 5 days before their earnings announcements and sell them just before the announcement.

Strategy B: pick stocks in the top percentile of 12-month returns. Buy them (individually) 5 days immediately after their earnings announcements and hold them for 5 days.

Strategy A is very profitable: the annualized excess return is 47% before costs. (To be taken with a grain of salt due to the large transaction costs associated with trading momentum strategies, especially if small-cap stocks are involved.) Strategy B is very unprofitable: the annualized excess return is -43% before costs.

So what are the ways we can make best use of this research?

Naturally, instead of buying the top percentile after the earnings announcements, we should have shorted the stocks, thus making Strategy B a reversal strategy instead.

Furthermore, what about the bottom percentile of stocks? Should we have shorted them prior to the announcements, and bought them after the announcements? If so, we would have a very nice dollar-strategy for you statistical arbitrageurs out there!
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