November 11, 2015

Hi-Lo Index as a Market Timing Indicator

My strategies use a market timing indicator to tell me when I should not be trading the strategy. The blog post, Avoiding Stock Market Crashes with the Hi-Lo Index of the S&P500, presented a very simple idea of using new highs vs new lows. The post tests trading the SPY & IEF but I wanted to know how well would it work on a S&P500 mean reversion strategy.

The Indicator

The Hi-Lo Index is calculated as the ratio of the number of S&P500 stocks that have reached new 3-month-highs minus those that have reached new 3-month-lows, divided by the number of stocks in the index. The article divided by 500 but the number of stocks in the index can vary around this number and since I have data to calculate the actual number, that is what I used. Then we apply a 40 day Moving Average to the indicator.

The market is good when the MA40 of Hi-Lo Index becomes greater than 5%. When it is below 5%, we will avoid taking new positions.

As a comparison, I will be testing using a simple Moving Average on the SPX as a market timing indicator.

Baseline Rules

Date range: 1/1/2005 to 9/30/2015

Setup

  • Stock is member of S&P500
  • Price is greater than $1
  • The 21 day moving average of Dollar Volume is greater than $10 million
  • The close is above the 200 day moving average
  • The close is in the bottom 20% of the daily range
  • The 2 period RSI is less than 20

Buy

  • Rank stocks from high to low using 100 day Historical Volatility
  • Place orders for the top ranked stocks so if they all get filled will be 100% invested. This means orders will often not get filled although lower ranked stocks may have
  • Set a limit buy order for the next day if price falls another .25 times 10-day average true range.

 

Exit

  • 2 period RSI greater than 80
  • Exit on open next day

Misc.

  • Maximum of 10 positions
  • 10% allocation per position
  • No margin is used

 

Baseline Results

151111a

The focus will be on CAR, Maximum Drawdown and the average of the 5 worst drawdowns.

Moving Average on SPX

A very common market timing method is applying a moving average to the SPX. My favorite being the 200 day and another popular length being the 100 day. The available spreadsheet has results for more moving average lengths.

The new additional setup rule is:

  • Close of SPX is greater than the 200 day of the moving average of SPX closes.

Moving Average Results

151111b

We can see the benefits and cons of adding a market timing filter. We had a drastic reduction in MDD and the average of the top 5 drawdowns. It came with a cost of reducing the CAR by 4% to 15%. In my book, this is a worthwhile tradeoff. Now the question is how does the Hi-Lo Index method compare?

Hi-Lo Index

The original rules used 5% as a cutoff and a 40 day moving average, which is highlighted below. I also tested different values with a small subset below and more values in the spreadsheet.

151111c

The CAR the Hi-Lo Index method is in the same range as using the moving average. The maximum drawdown is a little better. But two things caught my eye. The average % profit/loss took a big jump up. The best part, the average of the 5 worst drawdowns, dropped dramatically. From 16.30 to 12.20, or about 25%. WOW!

The suggested values from the original blog post, 5/40, also produced some of the best results here.

Spreadsheet

Fill the form below to get the spreadsheet with lots of more information. It contains the data for the HI-LO index so you can try it out yourself. It also includes yearly breakdown, other statistics and more variations.

Final Thoughts

This indicator has huge potential. I will have to apply it some of my current strategies to see how it works on them. I have current consulting client I must suggest that he try this on. The indicator is not easy to compute but it may be worth the effort. I suggest you try it on your short-term strategies.

Backtesting platform used: AmiBroker. Data provider:Norgate Data (referral link)

Good Quant Trading,

Fill in for free spreadsheet:

spreadsheeticon

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Matt - November 11, 2015 Reply

You could apply this same concept to other indicators as well. For example, instead of New Highs minus New Lows, you could use RSI(x) > 70 minus RSI(x) < 30 or even Close above MA(200) minus Close below MA(200). Once you have the mechanism in place to properly evaluate each member of an index and tally the results (which you obviously do), using other indicators should be straightforward.

    Cesar Alvarez - November 12, 2015 Reply

    Matt, those are interesting ideas. Maybe that will be a good following post if I get enough ideas form readers or think of them.

Quantocracy's Daily Wrap for 11/11/2015 | Quantocracy - November 11, 2015 Reply

[…] Hi-Lo Index as a Market Timing Indicator [Alvarez Quant Trading] My strategies use a market timing indicator to tell me when I should not be trading the strategy. The blog post, Avoiding Stock Market Crashes with the Hi-Lo Index of the S&P500, presented a very simple idea of using new highs vs new lows. The post tests trading the SPY & IEF but I wanted to know how well would it work on a S&P500 mean reversion strategy. The Indicator The Hi-Lo Index […]

Georg Vrba - November 14, 2015 Reply

The third thing that is significant is that market exposure is only 52% for the Hi-Lo Index timer, whereas for the 200-day MA timer it is 67%. That means additional income can be obtained by investing cash in interest bearing instruments.

Thank you for this useful contribution.

    Cesar Alvarez - November 14, 2015 Reply

    Thanks for mentioning that. I did notice that but forgot to write about it.

IMHO BEST LINKS FROM QUANTOCRACY FOR THE WEEK 9 NOV 15 — 15 NOV 15 | Quantitative Investor Blog - November 17, 2015 Reply

[…] Hi-Lo Index as a Market Timing Indicator […]

Joe - November 28, 2015 Reply

Hi Cesar,

Would you mind sharing your afl code for calculating the top 5 drawdown metrics?

Thank you.

    Cesar Alvarez - November 30, 2015 Reply

    Let me see how it easy it would be to share. If I do, I will put it on my AmiBroker page for others. I will email you if I do.

Paul - March 27, 2016 Reply

Cesar,

Have you thought about combining your sector rotation strategy with the Hi-Low Index strategy?

When the MA40 of the HI-LOW index is above 5% you are in the top sector(s) and when the MA40 moves below 5% you go to cash or bonds.

Thanks for sharing your ideas.

Paul

    Cesar Alvarez - March 28, 2016 Reply

    That is a good idea. I always like the inclusion of market timing indicators. I will have to add that to my research queue.

Robert Hawkins - May 20, 2016 Reply

Ref: “You can find it at https://alvarezquanttrading.com/amibroker/”

— I can’t see it there, Cesar?

Could you please clarify the calculation, I can probably do the rest.

    Cesar Alvarez - May 20, 2016 Reply

    Scroll down to the section labeled ‘Worst 5 Drawdowns’

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