Free Friday #16 – Market Regime Switching Models

Happy Friday!

For this Free Friday edition I want to talk about market regimes or market filters. I have a very simple intermarket filter or regime monitor to share.

The idea with market regimes or filters is to identify a condition or set of conditions that alters the market’s characteristics or risk profile. Ideally, you could find a bull and bear regime that would enable you to go long when in the bull regime and get into cash or go short when in the bear regime.

The simple regime filter I want to share was found using Build Alpha’s intermarket signals. It only uses one rule and creates a clear bullish and bearish regime.

The rule says that if the Close of eMini S&P500 divided by the Close of the US 10 Yr Notes is less than or equal to the 10 day simple moving average of the eMini S&P500 divided by the 10 day simple moving average of the US 10 Yr Notes then we are in the bull regime.

Here it is in pseudo-code assuming eMini S&p500 is market 1 and US 10 Yr Note is market 2.

Bull = Close1/Close2 <= SMA(Market1,10) / SMA(Market2,10)
Bear=Close1/Close2  >    SMA(Market1,10) / SMA(Market2,10)

Let’s verify with some numbers that we have a discernible difference in market activity before I start flashing some charts at you.

Here are the S&P500’s descriptive statistics when in the bull regime:

  • Average Daily Return: 1.20
  • Std Dev Daily Return: 17.49
  • Annualized Information Rate:

     1.09

Here are the S&P500’s descriptive statistics when in the bear regime:

  • Average Daily Return: -0.34
  • Std Dev Daily Return: 12.11
  • Annualized Information Rate:

      -0.44

This would definitely qualify as something of interest. Let’s take a look at the equity curve going long when ES, the eMini S&P500 futures, enter into the bull regime.

regime1

It actually performed quite well with no other rules or adjustments only trading 1 contract since early 2002. It even looks to have started to go parabolic in the out of sample data (last 30% highlighted).

Build Alpha now offers another check for validity -> The ability to test strategy rules across other markets. This is very important when determining how well a rule generalizes to new (and different) data. The user can select whatever markets to compare against, but in the example below I chose the other US equity index futures contracts. You can see Nasdaq futures in gold, Russell Futures in green, and Dow Jones futures in red.

regime1a

Now back to our Free Friday regime filter… Wouldn’t it be cool if the US 10 Yr Note performed well while eMini S&P500 was in the bear regime? That way instead of divesting from the S&P500 and going into cash we could invest in US 10 Yr Notes until our bull regime returned.

Well guess what… the US 10 Yr Note Futures do perform better in the bear regime we’ve identified.

The best part is… Build Alpha now let’s you test market regime switching strategies.

That is, invest in one market when regime is good and invest in another market when regime changes. This ability smoothed our overall equity curve and increased the profit by about 50%! Below is an equity curve going long eMini S&P500 in the bull regime and going long US 10 Yr Note Futures when the regime turns bearish.

regime2

Some major new additions coming to Build Alpha and I’ll be announcing them soon. As always thanks for taking the time to read these.

Happy Friday,

Dave

Email: David@buildalpha.com

Old Posts:

Thanks for reading,
Dave


1 thought on “Free Friday #16 – Market Regime Switching Models

  1. A really smart Build Alpha user perfectly summarized this post to me in an email:

    “Intuitively is this saying that if ES has tanked in the immediate short-term relative to the 10-yr then it should perform better going forward? The vice-versa If ES went on an immediate tear relative to the 10-yr then it should perform poorly going forward?”

    This is a pretty spot on summary of this market regime filter and I wanted to share it as I am not often the most concise writer and not too ashamed to admit it.

    Thanks Tyler K. Glad to know people are reading these!

    Best,
    Dave

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Risk Disclosure

FUTURES AND FOREX TRADING CONTAINS SUBSTANTIAL RISK AND IS NOT FOR EVERY INVESTOR. AN INVESTOR COULD POTENTIALLY LOSE ALL OR MORE THAN THE INITIAL INVESTMENT. RISK CAPITAL IS MONEY THAT CAN BE LOST WITHOUT JEOPARDIZING ONES FINANCIAL SECURITY OR LIFE STYLE. ONLY RISK CAPITAL SHOULD BE USED FOR TRADING AND ONLY THOSE WITH SUFFICIENT RISK CAPITAL SHOULD CONSIDER TRADING. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Hypothetical Performance Disclaimer

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.