Volatility's Influence on Mean Reversion Strategies

Have you ever observed the performance of your mean-reversion strategy seeming to deviate from expectations despite favorable indicators? Today, we explore how historical volatility can impact daily follow-through mean-reversion strategies in quantitative research. Dive into these new concepts that could potentially enhance trading strategies.

Mean Reversion Strategies: A Brief Overview

Let's revisit the fundamentals of mean-reversion strategies. Traders buy after down days and sell short after up days, anticipating price reversion to the mean. This strategy has gained prominence since 2000, particularly for broad market indexes such as SPY.

Volatility: The Overlooked Factor

You might wonder why introduce complexity with volatility when mean reversion seems robust. However, understanding how volatility influences trading performance is crucial for refining strategies, as it often goes unnoticed.

Historical Volatility's Impact

Examine how historical volatility affects mean-reversion strategies using 30-day and 100-day historical volatilities. Classify high volatility at the 75th percentile, low at the 25th percentile, and average as everything in between:

| Volatility Level | CAGR | Sharpe Ratio | % Correct | Avg Daily Return | |---|---|---|---|---| | High (10d) | 7.32% | 0.45 | 52.60% | 0.126% | | High (100d) | 5.28% | 0.32 | 51.00% | 0.087% | | Average | 0.62% | 0.03 | 50.30% | 0.013% | | Low (10d) | 2.25% | 0.29 | 51.00% | 0.036% | | Low (100d) | 1.47% | 0.18 | 51.20% | 0.025% |

Source: CSS Analytics

High volatility environments prove favorable for mean reversion, with 10-day volatility outperforming long-term volatility in returns. When volatility is low or average, following long-term trends yields better results than attempting daily reversals.

Short-term vs Long-term Volatility

Now analyze what happens when short-term (10-day) volatility differs from long-term (100-day) volatility:

| Scenario | CAGR | Sharpe Ratio | % Correct | Avg Daily Return | |---|---|---|---|---| | High Vol + Below Avg 10d/100d | 1.50% | 0.38 | 59.00% | 0.30% | | High Vol + Above Avg 10d/100d | 5.74% | 0.37 | 52.00% | 0.11% | | Low Vol + Above Avg 10d/100d | 1.05% | 0.38 | 53.60% | 0.09% | | Low Vol + Below Avg 10d/100d | 1.18% | 0.16 | 50.40% | 0.03% |

Source: CSS Analytics

In high volatility environments, follow-through returns are more consistent when short-term volatility slows down (i.e., below its long-term average). Conversely, low volatility periods show better performance when short-term volatility speeds up.