Stock Selection - Breakout - 1 Day Weakness Analysis

In further efforts to understand the factors that have effects on short term breakout returns, I have decided to look at the performance of the day before the breakout day to see if it has any effect.  Since mean reversion has been the dominant theme for the past decade, this post will see if a down day preceding the breakout day increases short term breakout returns.  I will define one day weakness by comparing the close one day before the breakout (C1) to the close two days before the breakout (C2).  Below are the baseline breakout results (no breakouts in the past two days) separated into percent groups:

I am using the Vanguard Total Market Index (VTI) component stocks as a proxy for the entire market, which contains 2401 stocks. The backtest analysis will span the time frame beginning on September 15, 1998 to September 15, 2009.

I began the weakness analysis by looking at the performance of breakouts when the close the day before the breakout was lower than the close two days before the breakout (the day before the breakout was a down day).  This was a preliminary analysis to determine if one day weakness could have an effect on the breakout performance.  The results of the analysis are shown below:

One day weakness appears to have limited potential when comparing the average return per trade to the baseline results.  The results show a marginal improvement (average difference between weakness and baseline results is 0.02%) for breakout levels between 1-6%. For breakout levels between 6-15%, the weakness results show an average difference of 0.12% on the average return per trade.  There is little difference between the baseline and the one day weakness results for breakout levels >15%.

Next, I separated the one weakness into separate levels to isolate the effect of each weakness level.  Below are the sample results for the 7-8% breakout group:

Using the results from each percent group, I compared the difference between the average return per trade for each weakness level and the average return per trade for the baseline results. I summarized the comparison in the following chart:

The values in the chart are the difference between the weakness level results and the baseline results for the same percent group. When the weakness return is greater than the baseline return the box is tinted green and when it is less than the baseline return the box is tinted red.  The tint is darker for values further away from 0%  The chart includes the results for each breakout percent group and each weakness level.  I included the average and median values for each grouping, as well as the baseline average return per trade for each percent group. The bold boxes highlight the maximum average return difference for each percent group.  Below is a chart summarizing the average and median return differences for each one day weakness level:

Most of the maximum returns occur at one day weakness levels C1<0.90*C2, which show an average difference in the average return per trade of 0.40%.  The only other weakness level that shows promise is the C1=(1.00-0.99)*C2 level, which has an average difference of 0.18%.  The average difference for all the results is 0.07%, and the median difference for all results is 0.02%.

The chart below summarizes the average and median return differences for each breakout percent level:

There is a dramatic difference between the average and median results which is due to the exceptional performance of the one day weakness level C1<0.90*C2 influencing the data.  In this case, the median is a better indicator of performance.  One day weakness seems to only impact the results for breakout levels between 7-15%.

The chart below shows the average return per trade for all breakout percent groups and one day weakness levels:

The values in the chart are colored green if the average return per trade is above 0% and red if the average return per trade is below 0%. The average and median values for each row (one day weakness level) are located in the two columns on the right side of the chart. The average and median values for each column (percent group) are located in the bottom rows. The baseline values (yellow) are located in the bottom row. The maximum average return per trade for each percent group is indicated by a thick border. All of the average returns greater than or equal to 0.22% (the max baseline return) are colored in blue font.
 
The average of all the returns is 0.16% and the median is 0.16%, which are greater than the baseline average of 0.09%. The average of all the maximum (thick border boxes) average returns is 0.55%. It is clear that breakouts greater than 15% still exhibit short term mean reversion behavior because the average return for that breakout level is -0.40%. Below is a chart comparing the average return per trade by breakout percent level with the baseline (three bottom rows from above chart):

 

The chart shows that most of the average returns are larger than the baseline returns, but median returns tell a different story.  The median returns for breakout levels between 1-7% are very similar to the baseline returns.  The median returns are larger than the baseline returns for breakout levels between 7-15%. One day weakness appears to have no effect on breakouts exceeding 15%.

Out of 88 tests for one day weakness, 32 had an average return per trade greater than 0.22%. Out of those 32 tests with returns greater than 0.22%, 6 occurred for weakness level C1=(1.00-0.99)*C2, 5 occurred for weakness level C1=(0.97-0.96)*C2, 10 occurred for weakness level C1<0.90*C2, and 20 occurred for percent groups between 6-10%. I ran a backtest for each breakout level and limited the results to one day weakness and breakout levels between 6-10%, which yielded an average return per trade of 0.29% compared to 0.20% for the same baseline breakout levels. 
I compared selected weakness results with the baseline results. Below is a chart summarizing the results of the backtest:

The chart above shows that the average return per trade exceeds 0.25% for one day weakness of C1< C2 and breakout percent levels between 6-10%, with a maximum average return of 0.31% for the 7-8% level.  The average return per trade exceeds 0.30% for one day weakness of C1=(1.00-0.99)*C2 and breakout percent levels between 6-9%, with a maximum average return of 0.47% for the 8-9% level.  The average return per trade exceeds 0.30% for one day weakness of C1<0.90*C2 and breakout percent levels between 1-15%, with a maximum average return of 0.71% for the 7-8% level.  This is substantially better than the baseline results which had a maximum average return per trade of 0.22%.

It does appear that one day weakness plays a small role in short term breakout returns, but the effect seems awfully specific and inconsistent.  Mean reversion still appears to play a big role with the returns for the lowest weakness level C1<0.90*C2, which showed very large average returns. The number of trades is low (<2000 per breakout level) and there may only be a small proportion of the results population accounting for the large returns.  I will not be including the one day weakness criteria in my breakout trading strategy.

ANALYSIS SUMMARY:

• One day weakness criteria will not be included in the breakout trading strategy.
• One day weakness improves returns on breakout levels between 7-15%.
• The best returns occurred for a weakness level of C1<0.90*C2 which had an average return per trade of 0.49%.  The second best returns occurred for a weakness level of C1=(1.00-0.99)*C2 which had an average return per trade of  0.27%.
• The average of all the maximum returns for each breakout level (thick border boxes) was 0.55%.