Summary
Leapday’s REACTION signals predict short term moves after earnings announcements. In this report we investigate whether aggregating our REACTION signals on busy earnings days to create a short market direction signal can be used as an overlay on SPY to enhance returns and provide downside protection. We find that our market direction signal can be used to boost annualized returns of SPY between 2016-20 from 15.1% to 26.3%, and decrease max drawdown from -33.7% to -20.7%.
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Introduction
In a previous report, we aggregated Leapday’s REACTION signals to create market direction signals that were used to successfully trade SPY. The short SPY signals were particularly strong, generating average returns of 0.61% over a 3-day hold, a hit rate of 53.2%, and winners that were 102% larger than losers. In comparison, shorting SPY between 2016-2020 and holding for 3 days has an average return of -0.19%, a hit rate of 37.5%, and winners that were 22 percent larger than losers given that this period encompasses an extended bull market.
This result raises the possibility of using our short signals as an overlay on portfolios with long market exposure, in which these signals can be used to enhance returns and provide downside protection. Below we outline the creation of this overlay.
Creating an Overlay on a Long Equity Portfolio
We start with the market direction signal from our previous report. To recap, we create a market direction signal to trade the market close on busy event days and hold this trade for 3 trading days by: (1) aggregating the company-specific REACTION scores of the t0 open + 60 min 4d signal and t0 close 3d signal for each day, as these correspond to the 3 day hold we are using; (2) averaging the aggregate t0 open + 60 min 4d and t0 close 3d score for each day to create an average daily score; (3) filtering for days in which event activity is in the top quartile of event days; (4) applying a trade threshold of +/- 8 to the average daily score to create a market direction signal that captures the strongest one-third of scores on tradeable days.
Next, we create 2 overlay strategies using the short signals:
Go Flat - If there is a short market direction signal, we exit our SPY position for 3 days and move to cash. We re-enter a long SPY position when there has not been a short market direction signal for 3 days. For example, if we have a short market direction signal before Monday’s close, we exit SPY on Monday’s close and move to cash. We buy SPY again on Thursday’s close (provided we have no other short signals between Tuesday and Thursday).
Go Short - If there is a short market direction signal, we exit our long SPY position and go short SPY for 3 days. We then exit this short position and re-enter a long SPY position when there has not been a short market direction signal for 3 days. For example, if we have a short market direction signal before Monday’s close, we exit long SPY and go short SPY on Monday’s close. We exit this short and re-establish a long SPY position again on Thursday’s close (provided we have no other short signals between Tuesday and Thursday).
Results
Below we present metrics from applying the 2 overlay strategies described above. This study uses a sample period between January 1, 2016 and December 31, 2020. There are a total of 47 short market direction signals that were generated during this period.
Below we look at the 3-day performance on those 47 signal days. We compare the performance of Staying Long SPY (i.e. – not using the signal) to the 2 overlay strategies of Going Flat and Going Short SPY. All of the returns in this analysis are appropriately adjusted for splits and dividends.
As the above metrics indicate, the short signals do well and are particularly helpful in preventing large short-term negative SPY returns, as indicated by the large Avg W / Avg L metric for the Go Short overlay. Next, we examine how this result translates into trading performance by comparing a buy and hold SPY position to the 2 overlay strategies.
As is evident above, these signals significantly impact profits and prevent large down swings in performance. The table below summarizes the portfolio performance for the three scenarios.
Using the signal to Go Short provides the best returns. However, for investors that are unable to Go Short due to their mandate or other constraints, hedging the SPY by Going Flat provides a large boost in returns over the long only strategy.
Discussion
We have shown that by aggregating company-specific REACTION scores into a market direction score an investor can substantially enhance returns and obtain downside protection by using the short signals as an overlay for a long equity portfolio. We believe these results exist because a large number of negative REACTION signals is a destabilizing factor in the market that drives big downward moves.
Investors can use this market direction signal in a variety of ways. Most obviously, they can use these signals as overlays to enhance returns and reduce drawdown in a long equity portfolio. A sophisticated investor will likely implement an options strategy in lieu of the methodologies described above. In addition, more active investors can use these signals as a risk management tool in existing long/short equity strategies. In a future post, we will examine how REACTION signals can be aggregated on a sector level to tailor more specific overlays.
Conclusion
In this report, we present an approach to create an overlay on SPY to enhance returns and provide downside protection. This overlay is based on aggregating Leapday’s REACTION signals to create a market direction signal. Short market direction signals are then used to either exit and Go Flat SPY when a signal is generated, or to exit and Go Short SPY when this signal is generated. By using the Go Flat overlay, an investor would boost annualized returns of SPY between 2016-20 from 15.1% to 20.8%, decrease max drawdown from -33.7% to -20.8%, and increase their Sharpe ratio from 0.84 to 1.19. By using the Go Short strategy, an investor would boost annualized returns of SPY from 15.1% to 26.3%, decrease max drawdown from -33.7% to -20.7%, and increase their Sharpe ratio from 0.84 to 1.34. These overlays can be used to enhance returns and reduce drawdown in any long equity portfolio.
Disclaimer
This material is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions. We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time. Hypothetical performance has many significant limitations and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.
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