Tuesday’s QQQ Move and Equity Index Mean Reversion Worldwide

Tuesday saw QQQ drop somewhat heavily, and for the third day in a row.  These three drops took us back to mid-August levels, blowing through a ton of support levels… My mean reversion senses are tingling!

QQQ 2012

So, let’s take a look at what happens in these situations by formulating a simple rule to capture them, that will then exit after the mean reversion has (hopefully) happened:

  • If QQQ is down at least 3 days in a row, and it closes below the 10-day intraday low, go long.
  • Close the position one day after QQQ closes above its 5-day SMA.

A simple rule, designed to capture big drops in hope for a bounce. The usual issues associated with catching falling knives come up.

Sometimes it works great…

good trade

April 2012

And others not so much…

giant loss

September 2001

But over time there is remarkable consistency:

Equity curve

Run-up & drawdown, assuming $100k per trade, including $0.005 per contract in commissions

Here are the stats:

stats

Note: dot-com bubble not included in these stats because they would look better than they really are over the long run.

Downside skew is never nice of course, is there something we can do to soften the biggest losses? As it happens in most cases with swing systems, adding a stop loss is generally a bad idea. Indeed adding a simple 3% stop loss would decrease returns, lead to a much more uneven equity curve, and also result in deeper and longer drawdowns. Getting fancier and adding various special rules to the stop (such as a period after getting stopped out during which trading is not allowed) does not significantly improve the results. The solution here is simply proper position sizing so that you can take the losses you have to take and still be comfortable.

Finally, is this just an accidental feature of the NASDAQ 100, or could we use it in other markets as well? Let’s have a look at a broad array of equity index ETFs:

country stats

Trades start at each ETF’s inception; dividends are included, commissions are not.

Well, there you have it…

Disclosure: Net long U.S., U.K., Singaporean equities.