Analyzing the Contrarian Approach
May 23, 2017
By: Sage Anderson
After some serious doldrums in terms of market volatility, the financial world was thrown a curve ball in mid-May when global equities turned sharply negative.
Interestingly, the move wasn't related to the recent French elections, which had pushed implied volatility higher (briefly) in early May. Instead, with the S&P 500 closing down more than 40 points, most were pointing to political uncertainty in the United States as the primary culprit.
While one can never be exactly certain what is moving markets, we do know that the VIX spiked in rather dramatic fashion only a day after news circulated regarding President Donald Trump’s decision to fire the Director of the FBI.
We'll have to wait for further developments related to that story, but a recent episode of Market Measures may be of interest in the meantime.
The focus of this particular episode was market strength/weakness, and highlighted tastytrade research examining the performance of a contrarian approach to such signals.
The question at hand was how a trading approach focused on fading market strength or weakness performed as compared to a strategy that followed the market’s prevailing direction.
If the one-day selloff observed in mid-May were to continue, this would be the type of scenario in which a trader might ask him/herself that very same question.
The first research presented on the show focuses on how a contrarian approach of selling the strongest and buying the weakest index ETFs (DIA, QQQ, IWM, SPY) has worked historically.
Using data from 2000, the study isolated the weakest and strongest performer each month of the DIA, QQQ, IWM, and SPY. The study then backtested shorting the prior month's strongest ETF, and buying the prior month's weakest ETF. For each, three trade management filters were applied:
manage for a net 1% gain on the position, or held for 2 months
manage for a net 2% gain on the position, or held for 2 months
held for 2 months
As you can see from the results below, each of the contrarian strategies produced a high success rate with positive gains:
Over the next half of the show, the Market Measures team examined the opposite trade (buying into strength and selling into weakness), in order to provide further context on relative performance of the contrarian approach.
Interestingly, the results showed negative returns for each of the three trade management styles when chasing the market’s prevailing direction.
Given the importance of this topic, and the complexity, we hope you'll take the time to watch the full episode of Market Measures when time allows.
This research could prove even more timely if the current slide in equity prices picks up speed over the coming days and weeks.
We hope you'll reach out at firstname.lastname@example.org with any comments are questions.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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