Is it a good regime filter? - Technical analysis and trading system

In this article we will analyze the use of the Momentum as a regime filter within a portfolio of ETF.

When we talk about market regime we refer to the phase in which we find ourselves: it can be, for example, a prolonged rise period (Bull Market), or a phase of weakness or reduced (Bear Market).

Understanding the market regime is essential because it allows us to adapt the operation and avoid being exposed when the context is not favorable.

The Momentum, which measures the strength and direction of price movements, can be used as a tool to distinguish these regimes and, therefore, as a filter that decides when to invest in the wallet and when to remain liquid.

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The composition of the ETF portfolio used in the analysis

For this study we built a portfolio based on four ETFs, which clearly represent the main financial asset class. The goal is not so much to maximize diversification, as to create a simple and robust basis on which to test the effectiveness of the filter.

The wallet is composed as follows:

Spy, replies the trend of the S&P 500 index, main USA EDUCATION benchmark.
EFA, replies the MSCI EAFE index, which includes Europe, Australia and Japan, offering exposure to developed markets does not use.
TLT, replies long-term American Treasury (20+ years), useful as coverage in moments of uncertainty and risk-off.
GLD, replies the price of gold, traditionally considered a good refuge.

This composition allows us not to focus on a single asset class, but to observe how the momentum behaves between very different tools. In this way it will be possible to check whether the use of a regime filter can bring benefits in the management of the wallet.

What is the momentum and how it can filter market regimes

Momentum is one of the most used indicators to evaluate the strength of a market. In practice, size if the prices of an asset are higher or lower than a certain past period.

If the value of the momentum is positive means that the prices have gained ground and therefore we are in a favorable phase. On the contrary, if the value is negative it means that the prices have fallen compared to the past and that the context is weaker.

In academic research, the Momentum has often been used to select the strongest qualifications to invest in, but in this study we use it, as mentioned above, as a regime filter.

In other words, when the momentum is above zero we interpret the market as in the phase risk on And therefore suitable for remaining invested. When it goes down below zero we consider it a signal of risk offwhich suggests reducing or suspending exposure.

Figure 1 shows the trend of the Momentum: you can clearly notice how the indicator oscillates above and below zero, marking the different moments of strength or weakness of the market.

Figure 1. Graphic representation of the Momentum indicator.

Momentum VS Mobile Media: comparison between the two indicators

To evaluate whether the momentum is really effective as a regime filter, we will compare it with the tool that more than any other is used for this purpose: the mobile average.

The logic is very simple. A mobile average represents the average price of an asset in a certain period of time. If the price is above the mobile average, it means that the prevalent trend is bullish and therefore the market is in a favorable phase (risk on). If, on the other hand, the price drops below the mobile, it is interpreted as a sign of weakness, therefore a less suitable phase to remain invested (risk off).

In Figure 2 we report a visual confrontation between Momentum and Mobile Media. It can be seen how both have the aim of distinguishing the positive market phases from negative ones.

Figure 2

The results of the analysis: which filter does it work best?

In Figure 3 we report the results of the two indicators applied to the ETF portfolio, calculated on different temporal lengths. The strategy backtest was carried out starting from September 2005, a period in which all four ETFs considered were available. The initial capital of the wallet was set at 100,000 dollars, with an allocation of $ 25,000 for each operation.

We also remind you that the periods used are expressed on bag days: for example, 20 corresponds to about a month, 60 to a quarter, 120 at a quarter and so on. This makes the comparison even more intuitive, because the different values can be traced directly back to reference time intervals commonly used by investors.

To make the comparison more objective we used a simple criterion: a point is assigned to the indicator which, for each period, shows the best relationship between Net Profit and DrawDown Massimo (NP/DD). In other words, we not only look at the absolute gain, but how much that profit is “robust” with respect to the risk supported.

What emerges is interesting. The 200 -period mobile average, which represents the classic regime filter used by many large investors (for example Paul Tudor Jones), has clearly beaten the Momentum. If we limited ourselves to analyzing only this configuration, we could therefore conclude that the momentum does not make sense as a filter compared to the classic mobile average.

However, observing the other time horizons, we see that the situation changes: in most cases it is precisely the Momentum that prevails, with better NP/DD relationships than the mobile average. In particular, the best result is achieved with a Momentum calculated at 120 periods, which corresponds roughly to a four -month -old contracted.

In summary, if the mobile average at 200 periods remains a very solid filter and used for decades, the analysis on multiple time horizons shows that the Momentum can offer equally valid results, and in some cases higher.

Figure 3

Focus on the Momentum at 120 days: results and performance

Let’s proceed now by analyzing the strategy, applied to the wallet, which uses the Momentum to 120 periods. Observing the Equity Line (Figure 4), it affects the ability of the strategy to contain the losses during particularly difficult market phases: the collapse of 2008 and the most recent one of 2022, although present, have not had such a profound impact compared to what was seen on the market as a whole.

The result is a curve of profits that shows regular and much more stable growth than that of the equity indices.

Figure 4. Equity Line of the strategy with the Momentum indicator applied to the wallet.

On the other hand, moving on to the summary table of performance (Figure 5), an annual return of 6.24%emerges, which might seem modest.

However, what makes the result interesting is the ratio between performance and risk: the Massimo DrawDown was in fact slightly less than 13,000 dollars, equal to about 13% of the initial capital.

Considering the simplicity of the rule adopted, it is a total solid and satisfactory performance.

Figure 5

Final considerations: when to use the momentum in the management of portfolio

The results shown highlight how the Momentum at 120 days, despite its simplicity, manages to provide a certain protection in times of crisis and to contain the drawdown significantly.

Of course, this is not the only way in which the indicator can be used. The Momentum can in fact be used as an operational trigger, as a filter on shorter horizons, or still as a criterion for the ranking between different assets, as mentioned above.

It is important to underline that the portfolio analyzed, although there is a lower performance than a traditional share investment, has a significantly different degree of exposure. There were periods in which the strategy was completely flat, and others in which on an initial capital of $ 100,000 the actual investment was limited to only 25,000, since only one of the assets inside the wallet was in the risk-on regime. This implies that, with the same risk assumed, the results obtained could become even more interesting, confirming that the Momentum can be a useful tool to be integrated into different portfolio logic.