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Optimization Mean Reversion - Alvarez Quant Trading

The document discusses how optimization runs for trading strategies tend to exhibit mean reversion when tested on new time periods. The author conducted an optimization of a mean reversion strategy over 2000-2012 and found the top strategies significantly underperformed when the same optimization was run on 2013-2015 data, with average returns decreasing and ranks changing. Specifically, only 6% of the top strategies from 2000-2012 remained in the top decile over 2013-2015, demonstrating that optimization results can be unreliable for future performance. The author advocates not choosing strategies at the extreme tops of optimization results and setting lower expectations for out-of-sample performance.

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139 views5 pages

Optimization Mean Reversion - Alvarez Quant Trading

The document discusses how optimization runs for trading strategies tend to exhibit mean reversion when tested on new time periods. The author conducted an optimization of a mean reversion strategy over 2000-2012 and found the top strategies significantly underperformed when the same optimization was run on 2013-2015 data, with average returns decreasing and ranks changing. Specifically, only 6% of the top strategies from 2000-2012 remained in the top decile over 2013-2015, demonstrating that optimization results can be unreliable for future performance. The author advocates not choosing strategies at the extreme tops of optimization results and setting lower expectations for out-of-sample performance.

Uploaded by

coachbiznesu
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Optimization Mean Reversion – Alvarez Quant Trading 08.10.

2018, 00(03

Optimization Mean Reversion


July 13, 2016

Often one runs a optimization of a testing idea, then using some set
metrics from these results, one picks a variation to trade. What often
comes as a surprise to people, and myself the first time I saw this, is that
your optimization runs are often mean reverting. What do I mean by this?

For example, you have a 100 run optimization from 2000 to 2012. Now
you sort by your metric, say Compound Annual Return. Now do the same
optimization from 2013 to 2015. You will notice that your top runs from
the first period moving toward the middle of the second period. And your
bottom runs of the first period moving to the middle in the second period.
Let us look at some tests and data.

The Test
Period 1 from 1/1/2000 to 12/31/2012. Period 2 from 1/1/2013 to
12/31/2015.

Buy Rules
Stock is member of S&P500 index
Close is under 5 day moving average for (3,4,5,6,7) days
Stock closes in the bottom (10, 20, 30, 40, 50)% of the daily range.
This is known as Closing Range or Internal Bar Strength
Close is above the (50,100,150,200) day moving average
Close of SPX is above the 200 day moving average of SPX
Enter on next open

Sell Rules

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Close is above 5 day moving average for (1,2,3) days

This is a simple mean reversion strategy. I picked the number of


parameters to optimize on so I would get enough variations to give my
deciles enough samples.

Analysis
Given the above rules, this produces 2520 variations. I ran an optimization
over the first time period. I then sorted the data by Compound Annual
Return and divided it into deciles.

The CAR of the SPY during this period is 1.70%. An interesting thing is
wide the range is. Part of this is explained because some of the variations
produce very low exposure.

Comparing to 2013 to 2015


Next, I ran the same optimization over the second time period. For each
decile of the first time period, I looked at each variation to see what the
rank was in the second time period along with the CAR. From this I
computed the average CAR and average change in rank.

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First notice that the 2013-2015 CAR is a much narrower range. The
average delta change shows the biggest changes at the end deciles with
more narrowing as one moves towards the middle decile. We have mean
reversion of the optimization runs. Does this apply to all optimization
runs? I don’t know but my guess is that it does to some extent.

Now the last several years mean reversion trading has seen the edge
diminish and this could be part of what we see. Although the average CAR
for the second time period is higher it has done much worse than the SPY
CAR which is 14.03%.

Top Decile
Let us break down that top decile.

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Optimization Mean Reversion – Alvarez Quant Trading 08.10.2018, 00(03

This table shows what percent of top decile in the first period ended up in
each decile of the second period. As we can see only 6% of the top decile
runs in the first period ended up in the top decile in the second time
period. Ouch! And .8% fell all the way to the bottom. The worst drop went
from a rank of 159 to a rank of 2310. One piece of good news is that 77% of
the runs stayed in the top 5 deciles.

Think about this numbers and if you do out of sample testing.

Spreadsheet
Fill the form below to get the spreadsheet with lots of more information. It
contains all 2520 runs with yearly returns and decile information. A pivot
table is included so you can do your analysis.

Final Thoughts
This is one reason when choosing a variation to trade from an optimization
run that I do not like to pick anything near the top. I also set my
expectations for future performance to be lower. In my next post, I will
dive more into this topic. Post any comments on what you data you would
like to see from this.

Backtesting platform used: AmiBroker. Data provider:Norgate Data

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(referral link)

Good Quant Trading

Fill in for free spreadsheet:

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