When quantitative traders come across indicators that seem to produce results, our first instinct is usually to build them right into our strategy as trade signals. Surprisingly, this often leads to reduced overall returns. It can often be much more advantageous to use the additional indicator as a filter, as opposed to an entry/exit signal.
There is a post from Qusma that does an interesting job of illustrating this idea. The author develops an extremely simple indicator that produces very successful backtesting returns. However, when that indicator is brought into the author’s existing strategy, the overall returns plummet. The author then makes a slight adjustment, and the new indicator significantly improves the original strategy.
The CRTDR Indicator
CRTDR is just a fancy acronym that the author came up with to describe an indicator that measures where an index closes relative to its daily range. The author later added that this concept is also known as Internal Bar Strength (IBS).
The indicator is calculated by taking the difference between the close and the low of the day and dividing it be the difference between the high and the low of the day. This will return a number between 0 and 1 that is the percentage of the daily range that is represented by the close.
The author points out that while this may seem like an overly simplistic concept, it actually does a very impressive job of predicting the following day’s market action. He also has the backtesting results to back up that claim:
Backtesting Qusma’s CRTDR Indicator
The author broke the CRTDR numbers into four quartiles and then backtested the indicator on the SPY and QQQ. The results show that when either of the indices closed in the bottom half of the day’s range, the following day’s return was, on average, positive. When the indices closed in the bottom quartile, the next day’s average returns were even more impressive.
The article contains backtesting results for 35 different ETFs where a long position is taken when the CRTDR is less than 45% and a short position is taken when the CRTDR is greater than 95%. This strategy produced an average win rate approaching 60% and profit factors ranged from 1.02 to 2.19 depending on the ETF.
These results indicate that the CRTDR indicator by itself could be developed into a profitable mean reversion strategy. The author suggested that improvements like changing the number of days used in the calculation, adjusting to include overnight price changes, or creating a moving average derivative might make the CRTDR indicator even more useful.
The CRTDR Filter
The article takes an interesting twist when the author explains that he is not actually using this apparently profitable indicator. He says that he prefers the results of the mean reversion strategy he is already trading using Cutler’s RSI indicator.
The author then provides the backtesting results of a strategy that would take signals from both the CRTDR and RSI indicators. The combined strategy produces significantly lower returns than the RSI indicator did without the CRTDR addition.
While using the two indicators in tandem didn’t improve returns, using the CRTDR indicator to confirm the RSI trades did. The article contains a matrix that shows that using a CRTDR value of 50% as a filter would eliminate a portion of the RSI indicator’s losing trades. Combining the indicators in this manner produced a dramatically more profitable strategy than using the RSI by itself.