Tuesday, April 8, 2008

Regression outlier trading via Excel

Now that we know how to import data into Excel, let me explain a simple technique for an edge the public crowd largely remains clueless of. I used to apply it myself but not today as I now utilize strategies that require less patience, and hence release of this information does not conflict with my own trading interests.


Basic Concept

This analysis basically exploits statistical outliers. Exponential growth does not sustain (but decay does), both in nature and financial markets. Fundamentally, exponential growth of stock prices occur when the public crowd drifts off to fantasy land and keeps buying while institutional traders await to take profit.

To exploit this phenomenon, you search for growing stock(s) and make downside bets as prices surpass exponential levels. A second degree polynomial regression analysis makes this possible. Profit taking, or short-covering, occurs when price returns to the regression line. See below for steps.


Steps

1) I have decided to use data for SPY from 2001 to today, basically from the beginning of the last bull market.

2) With daily “High” prices studied and highlighted, click on the “Chart Wizard” button. (Because the strategy calls for downside bets, the optimal entry levels would lie in the historical-high statistics.)

3) Choose XY (Scatter Graph)

4) Keep clicking “next” until you see “As New Sheet” or “As object in”, and choose As New Sheet, and name it whatever, in this case “SPY Regression”, and press “Finish”.

5) Once the chart becomes opened, click on “Tools”, then “Add Trendline”, and pick Polynomial, order “2”, and then hit “OK”.

6) Now the chart holds the regression line nicely for the historical data, woohoo!


Applying This Edge

  • The regression line must curve upwards
  • Take short position(s) as price jumps up way above the regression line
  • Cover position(s) as price reverts back to regression line

As I’ve stressed in the past, do NOT apply a hard stop loss. That would seriously hurt performance. Remember that this strategy only works on the downside, not upside. If you do not understand why betting on failure has a higher expectancy, read this post.

Good trading.

12 Reflections:

alexandroid said...

Interesting idea. =)

Do I understand correctly that a) this works mostly for bull markets only and b) the best way to apply this is to plot a chart on some time window and not on the entire available data?

Rocko Chen said...

Yes this occurs more often in bull markets, but not always. The time-step you apply vary, but when I used it I began each period at a recent "bottom".

(You can get more accurate entries and exits using a professional statistical software like Minitab, but it takes a lot more work than Excel)

alexandroid said...

>> You can get more accurate entries and exits using a professional statistical software like Minitab, but it takes a lot more work than Excel

Excel should be enough -- LINEST + x^2 and x as inputs will do the same approximation. =)

Rocko Chen said...

Well, by accuracy of entries and exits, I meant with standard deviations drawn from the mean and Excel does not hold these functions.

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