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I would like to take advantage of a volatile market by selling highs and buying lows. As we all know the RSI indicator is very bad and I want to create a superior strategy for this purpose.
I have tried to model the price using a time varying ARMA process, with no success for now.

Any other ideas?

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Not quite what you want, but have you considered a "scale" strategy? Buy and sell at regular price intervals, but always sell one interval higher than where you buy? –  barrycarter Feb 1 '11 at 3:52
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I'm not sure asking for strategy ideas is going to garner an appropriate answer. That's like posting on Hacker News, Ask HN: What should my business model be? –  chrisaycock Feb 1 '11 at 4:24
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"Those who say don't know. Those who know don't say. Lao-tzu, Tao Te Ching" –  Shane Feb 1 '11 at 4:26
    
Added a question to meta to discuss this: meta.quant.stackexchange.com/questions/11/… –  Shane Feb 1 '11 at 15:06
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This link is quite interesting I think arxiv.org/abs/0808.1710 –  RockScience Feb 2 '11 at 5:54

1 Answer 1

up vote 6 down vote accepted

Your question's title suggests the market prices are mean reverting. I strongly suggest verifying that assumption via one of the usual tests, such as the Augmented Dickey-Fuller test (implemented in the tseries package of R by the adf.test function, and in other R packages, too).

If the market is truly mean reverting, a possible strategy is

  1. Detrend the data.
  2. Monitor the market for an extreme high or extreme low, based on its historical range.
  3. Buy or sell-short the market at those extremes.
  4. Cover at a logical point: at the mean or at the half-way point, for example.
  5. Repeat.

Detrending is useful to eliminate the long-term trend (in stocks) or eliminate the effects of carry (in futures). "Extreme highs" and "extreme lows" must really be extreme: I look for prices in the upper 90 to 95th percentile or lower 10th to 5th percentile, based on a few years of history.

Buying or selling-short at the extremes is fine ... unless the market decides to exceed its historical limits, in which case you'll experience drawdown, potentially large. I use a momentum filter and that helps but it's not perfect.

My experience is mostly in trading mean-reverting spreads. Your mileage may vary.

(PS - I found no connection between the RSI indicator and mean reversion. I don't use it.)

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Thanks for you input. I have been looking with much interest at your website and found your papers very good. I can see that you sometimes look at mean reversion in spread using futures. How do you roll from one contract to another and don't you think that you may break the cointegration each time you roll? –  RockScience Feb 7 '11 at 7:02
    
@fRed For rolling futures, I use the standard techniques; see "A Compete Guide to the Futures Markets", for example. Yes, rolling contracts can cause several problems, including spurious cointegration. This mostly happens in physical commodities, where spot supply & demand problems can wreak havoc with the futures curve. Also, the spread has its own contango and backwardation, and you need to watch it carefully. Spread profits can evaporate when futures expire and you roll your positions forward. –  pteetor Feb 7 '11 at 21:05

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