TASC 2013-02 | Volatility Switch (McEwan)

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Traders' Tip text

In this month's issue, author Ron McEwan presents a simple, intuitive yet seemingly effective new indicator whose purpose is to act as a filter in a trading strategy, facilitating it to adapt to changing market conditions. A change from a trending mode to a mean reverting one is measured through a ratio dividing the number of bars when the Historical Volatility (HV) of the daily close price change in a given lookback period was lower or equal to today's daily ROC's HV.

To take advantage of Volatility Switch in Wealth-Lab's charts, code- and interactive rule-based strategies, all it takes is to install (or update if you haven't done that already) the TASCIndicators library from the www.wealth-lab.com site to its latest version.

To illustrate the application of the new regime filter, we created a demo system that takes entries and exits depending on the market's volatility switch state: above 0.5 it's considered choppy with a potential for mean reversion, and at or below 0.5 it's more likely to trend.

Entry rules

If volatility switch is in trend mode, buy at market next bar when today's close crosses above the 10-day simple moving average of close price
If volatility switch is in mean reversion mode, buy at market next bar when the 7-day RSI crosses above 30

Exit rules

If volatility switch is in trend mode, sell at market next bar when today's close crosses below the 10-day simple moving average of close price
If volatility switch is in mean reversion mode, buy at market next bar when the 7-day RSI crosses below 60

Figure 1. Daily chart of SPY illustrating the application of a trend/mean reversion trading system powered by McEwan's Volatility Switch filter.

We ran a backtest with $10,000 per trade on 5 years of SPY's Daily data. With real world position sizing and trading costs rules applied, the simplistic system was able to beat Buy&Hold, returning a 26% net profit figure (vs. -6%), proving that the regime switch filter can become a valuable addition to a trader's arsenal. The system's C# code for Wealth-Lab can be found below:

Figure 2. Chart of strategy's equity curve vs. Buy&Hold.

WealthScript Code (C#)


using System;
using System.Collections.Generic;
using System.Text;
using System.Drawing;
using WealthLab;
using WealthLab.Indicators;
using TASCIndicators;

namespace WealthLab.Strategies
{
	public class EwanRegimeSwitchStrategy : WealthScript
	{
		private StrategyParameter paramPeriod;
		
		public EwanRegimeSwitchStrategy()
		{
			paramPeriod = CreateParameter("Period", 21, 2, 100, 1);
		}
		
		protected override void Execute()
		{
			int period = paramPeriod.ValueInt;
			VolatilitySwitch voltSwitch = VolatilitySwitch.Series( Close,period );

			for(int bar = GetTradingLoopStartBar( period * 3 ); bar < Bars.Count; bar++)
			{
				bool regimeSwitchIsTrending = voltSwitch[bar] > 0.5 ? false : true;
				
				if (IsLastPositionActive)
				{
					Position p = LastPosition;
					
					if( regimeSwitchIsTrending )
					{
						if( CrossOver( bar, Close, SMA.Series( Close,10 ) ) )
							SellAtMarket( bar+1, p, "Trend exit" );
					}
					else
					{
						if( CrossUnder( bar, RSI.Series( Close,7 ), 60 ) )
							SellAtMarket( bar+1, p, "MR exit" );
					}					
				}
				else
				{
					if( regimeSwitchIsTrending )
					{
						if( CrossOver( bar, Close, SMA.Series( Close,10 ) ) )
							BuyAtMarket( bar+1, "Trend" );
					}
					else
					{
						if( CrossOver( bar, RSI.Series( Close,7 ), 30 ) )
							BuyAtMarket( bar+1, "Mean reversion" );
					}					
				}
			}
			
			ChartPane vrsPane = CreatePane( 30,true,true );
			PlotSeriesOscillator( vrsPane, voltSwitch, 0.5, 0.499, Color.Coral, Color.DarkGreen, Color.Transparent, LineStyle.Solid, 1 );
			HideVolume();
		}
	}
}