Mean-Reversion and Momentum Regime Switching

This article describes an ETF trading strategy with mean-reversion and momentum regime switching. The Sharpe ratio of the strategy is greater than 1.

The long-only trading strategy with four liquid ETFs may be used as the basis for developing more advanced strategies that incorporate regime switching. Mean-reversion usually works well in bear markets due to short-squeeze rallies, and momentum may work well in bull markets. The strategy uses a regime switch indicator to trade the mean-reversion and momentum regimes.

Strategy rules

Backtest range: 01/03/2003–12/29/2023

The annualized return is 10.1%, and the maximum drawdown is 16.5%. The Sharpe ratio is 1.14. The win rate is 54.3%, and the number of trades is 1,490. The strategy’s P/L skew is 1.64 and the equity skew is 0.18 in the test period.

The strategy fell 12.1% in 2022, but in 2023 it has more than recovered with a gain of 22%. The best year has been 2020, with a nearly 30% return.

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About the risks of mean-reversion strategies

Mean-reversion methods are risky since the trades typically go against the short-term trend. Stop-loss orders cannot be employed efficiently because, in the majority of instances, they destroy profitability.

Mean-reversion strategies are only good for experienced traders who know how to manage risk and are willing to take on big risks.

When using a profitable mean-reversion strategy, inexperienced traders may lose money because they are afraid to act on signals that are risky at first but pay off in the long run.

Disclaimer: No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

Charting and backtesting program: Amibroker. Data provider: Norgate Data

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