Short-Term Diffusion – A Type of Breadth Indicator
With the launch of Trading Stocks just around the corner I thought that it would be fun this week to explore one of the quantified breadth filters that clients will have access to in our new platform. The indicator that I’ll feature this week falls into a set of indicators referred to as diffusion indicators. These belong to the breadth class of indicators because they include an entire set of equities in their calculation as opposed to a single equity. As a result they can be effectively used to analyse the internal strength of a market, analyse the degree to which the market is overbought/oversold and they work very well as high level risk filters to control position size and directional risk. I’ll be using these extensively on a daily basis trading a live account that you’ll be able to follow for free from the homepage of our new site. So without further ado let’s dig into our indicator.
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How to exploit Mean Reversion with Breadth?
Equity prices tend to mean revert in the short-term. In other words, they tend to move from periods of lows to highs and vice versa. Our breadth indicator will look to capitalise on this tendency, but instead of analysing a single equity in isolation, we’ll view the entire liquid universe to get a sense of how stretched the market is in the short-term and therefore how likely it is to reverse. To test the effectiveness of our indicator I’ll apply it to the Satrix 40 ETF (JSE Top 40 ETF).
One way to exploit mean reversion by using market breadth is to analyse the percentage of stocks trading above/below a five day simple moving average. The basic premise is that when the percentage approaches 100% on either side of the moving average then the market is probably stretched in that direction and likely to reverse. For instance, if more than 90% of stocks are trading below their five day moving average then we’d take a long position in the Top 40 ETF in anticipation of the market reverting to more normal levels. Here are the precise rules that I used for my testing:
Long only in the Satrix Top 40
Entry: Percentage stocks above their five day moving average < 10% (Market oversold). Enter at Close.
Exit: Percentage stocks above their five day moving average > 50% (Market recovered). Exit at Close.
The results are in!
Despite the simplicity of the system, the quantified performance is fantastic. The model enjoyed a win rate of 79% and generated an average trade return of +1.81%. The average hold for a trade was 4.21 days. Although I personally wouldn’t trade this system on a standalone basis, it does offer tremendous value as an additional overlay in a more fully developed system. This is precisely how I’ll be using this indicator in my live trading. You’ll able to follow my analysis daily for free when we go live next month.
Thanks for reading. As always I welcome your comments.