Exploring the DVI Indicator: Up vs Downtrending Markets

30Jul10

In this series we’re analyzing the DVI (read part one and two), a contrarian intermediate-term indicator from CSS Analytics (click to calculate).

In this post I want to look at how the DVI has performed going long and short in up versus downtrending markets and present a simple modified strategy that has solidly outperformed the original.

The table above shows S&P 500 index results since 1970 the day following bullish (< 50%) and bearish DVI readings (> 50%) in both uptrends (S&P 500 > 200-day moving average) and downtrends (S&P 500 < 200-day).

I’ve assumed we went long bullish and short bearish readings. Results are from close-to-close. See end of post for assumptions about dividends and trade frictions.

The DVI has been most predictive when going long in uptrends (column 1), less predictive going either long or short in downtrends (columns 2 and 4), and poorly predictive going short in uptrends (column 3).

Clearly the trend is an important consideration in interpreting the DVI.

Modified Strategy

Based on the above observations, here’s a just-for-giggles modified strategy.

Strategy rules: take a full position on bullish/uptrend readings, half position on both bullish/downtrend and bearish/downtrend readings, and no position on bearish/uptrend readings. Additionally, because of what we found in our previous post, don’t take a short position when DVI exceeded 90%.

[logarithmically-scaled, growth of $10,000]

Above are the original long-only strategy results from our first post (grey) versus this modified strategy (red) trading the S&P 500 from 1970.

Numbers for the number-lovers…

This is a highly curve-fit set of rules, but results are a significant improvement over the original, especially in terms of managing drawdowns.

The Why

The fact that longs have outperformed in uptrends and shorts in downtrends is obviously no surprise (“the trend is your friend” and all that jazz).

The fact that shorts have (irrespective of the trend) been the worse performing is partially due to the generally bullish trend of the market, but more a result of the fact that it’s a real pain in the rear to short using anything other than very short-term indicators (such as RSI(2)).

Long profits can come from multiple places: long-term trend-following and short and intermediate-term mean-reversion. But predictable short profits tend to only come from very short-term (read: technically-driven) mean-reversion (read more).

One Last Thought…

This has been a very cursory look at the DVI in up versus downtrending markets; a lot more could be done to look at other measures of the trend and other thresholds for bullish/bearish DVI readings.

But I hope that, at the very least, we’ve sparked some ideas for folks interested in exploring the DVI further in their own trading.

[Edit: click for a summary of all posts in this series on the DVI indicator]

Happy Trading,
ms

Test assumptions: (a) I’ve calculated the DVI using the S&P 500 cash index (which traders generally use), but calculated returns based on daily dividend-adjusted data (dividends interpolated from quarterly data), (b) results are frictionless (i.e. do not account for transaction costs/slippage) but could be closely reproduced in today’s market using certain mutual funds less part of an annual expense ratio, and (c) in the strategy test I assumed a return on cash of half the nearest 13-week Treasury.

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