In the last post I introduced a method to normalize returns using the VIX to improve upon a standard momentum or trend-following strategy. There are many possible extensions of this idea, and I would encourage readers to look at one of the comments in the previous post which may inspire some new ideas. The motivation for this method was to provide an alternative approach that is more broadly applicable to other assets than a VIX-based strategy (which is more appropriate for equities). This method uses the standard error of the mean to adjust returns instead of using the VIX, which is a proxy for market noise. The logic is that returns should be weighted more when predictability is high, and conversely weighted less when predictability is low. In this case, the error-adjusted moving average will hopefully be more robust to market noise than a standard moving average. To calculate the standard error, I used the 10-day average return to generate a forecast, and then took the 10-day mean absolute error of the forecast. To normalize returns, I divide each return by this standard error estimate prior to taking a 200-day average of the re-scaled returns. The rules for the ER-MOM strategy are the same as in the last post (although poorly articulated):
Go LONG when the Error-Adjusted Momentum is > 0, Go to CASH if the Error-Adjusted Momentum is < 0
Here is how this strategy compares to both the VIX-adjusted strategy and the other two baseline strategies:
The error-adjusted momentum strategy has the best returns and risk-adjusted returns- edging out the previous method that used the VIX. In either case, both adjusted momentum strategies performed better than their standard counterparts. One concept to note is that the benefit or edge of the adjusted momentum strategies tends to be more significant at longer trend-following lookbacks. This makes sense because there are likely to be a wider range of variance regimes throughout a long stretch of time than over a shorter lookback. Adjusting for these different variance regimes gives a clearer picture of the long-term trend. Using the historical standard deviation is also a viable alternative to either using the standard error or the VIX, and there are a lot of other ways to measure variability/noise that can be used as well.