Mean-Reversion (IBS)
A short-term contrarian strategy using Internal Bar Strength (IBS) to identify daily overreactions. ETFs closing near their daily low tend to rise the next day, while those closing near their high tend to fall. Simple, powerful, and well-documented.
Overview
The Internal Bar Strength (IBS) strategy exploits a well-documented daily mean-reversion effect in ETF prices. IBS measures where the closing price falls within the day's trading range: IBS = (Close - Low) / (High - Low). Values near 0 indicate "cheap" (closed near the low), while values near 1 indicate "rich" (closed near the high).
Research by Pagonidis (2013) found that ETFs with low IBS (below 0.2) tend to rise the next day by an average of 38 basis points, while those with high IBS (above 0.8) tend to fall. This creates a simple contrarian opportunity: buy oversold ETFs, sell overbought ones.
The effect is attributed to intraday overreactions that get corrected the following day. A dollar-neutral strategy sorting ETFs by IBS—buying the bottom decile and selling the top decile—can generate significant alpha, though transaction costs must be carefully managed.
Key Insight
Internal Bar Strength (IBS) Rankings
ETFs ranked by today's IBS value.IBS < 0.2 = Buy (oversold).IBS > 0.8 = Sell (overbought).
Research
The IBS effect is one of the most robust short-term anomalies in equity markets. Multiple studies confirm that daily price extremes tend to reverse, creating profitable mean-reversion opportunities in ETFs and indices.
The Mathematics
In Plain English
The math behind this strategy is straightforward. Here's what you're actually doing:
- 1Calculate IBS for each ETF using the day's high, low, and close prices
- 2IBS near 0 means the ETF closed near its daily low ("cheap")
- 3IBS near 1 means the ETF closed near its daily high ("rich")
- 4Buy ETFs with IBS below 0.2 (oversold)
- 5Sell/short ETFs with IBS above 0.8 (overbought)
- 6Hold overnight and close positions the next day
That's it. The formulas below just express this process precisely.
1Internal Bar Strength (IBS)
Where P_C is the closing price, P_H is the daily high, and P_L is the daily low. IBS ranges from 0 (closed at low) to 1 (closed at high).
2Buy Signal
When IBS is below 0.2, the ETF closed in the bottom 20% of its daily range. This "oversold" condition predicts positive next-day returns.
3Sell Signal
When IBS is above 0.8, the ETF closed in the top 20% of its daily range. This "overbought" condition predicts negative next-day returns.
4Cross-Sectional Strategy
Sort ETFs by IBS. Go long the bottom decile (lowest IBS) and short the top decile (highest IBS). This dollar-neutral approach profits from mean reversion across the universe.
Handling Edge CasesNote
If High = Low (no range), IBS is undefined. In practice, exclude such days or set IBS = 0.5. Also filter out days with very small ranges to avoid noise.
Transaction CostsNote
This is a high-turnover strategy. Transaction costs significantly impact profitability. Use liquid ETFs with tight spreads. Consider combining with other signals to reduce trade frequency.
Strategy Rules
Universe Selection
- Use liquid equity ETFs (SPY, QQQ, sector ETFs, country ETFs)
- Require minimum daily volume (e.g., $50M+ average)
- Ensure tight bid-ask spreads to minimize transaction costs
- Consider 10-30 ETFs for diversification
- Exclude leveraged and inverse ETFs
Signal Calculation
- 1Calculate IBS daily after market close
- 2IBS = (Close - Low) / (High - Low)
- 3Filter out days with very narrow ranges
- 4Rank all ETFs by IBS from lowest to highest
- 5Identify bottom decile (buy candidates) and top decile (sell candidates)
Entry & Exit Rules
- Enter positions at the close or next-day open
- Buy ETFs with IBS < 0.2 (or bottom decile)
- Sell/short ETFs with IBS > 0.8 (or top decile)
- Exit positions the following day (1-day hold)
- Equal-weight or volatility-weight positions
Risk Management
- 1Size positions to account for overnight gap risk
- 2Consider maximum position size per ETF (e.g., 10%)
- 3Avoid trading during high-volatility events
- 4Monitor for trending markets where mean reversion fails
- 5Track and limit transaction costs carefully
Implementation Guide
IBS is straightforward to calculate and implement. The main challenges are managing transaction costs and executing at favorable prices given the short holding period.
Define Your ETF Universe
Select a diversified set of liquid ETFs. Include sector ETFs, country ETFs, or broad market ETFs. Liquidity is critical given the daily trading frequency.
- U.S. sectors: XLK, XLF, XLE, XLV, XLY, etc.
- Country ETFs: EWJ, EWG, EWZ, FXI, EEM, etc.
- Broad market: SPY, QQQ, IWM, DIA
- Minimum average daily dollar volume: $50M+
Calculate Daily IBS
After the market close each day, calculate IBS for each ETF. You'll need daily OHLC (Open, High, Low, Close) data.
- IBS = (Close - Low) / (High - Low)
- If High = Low, skip that ETF for the day
- Data sources: Yahoo Finance, Alpha Vantage, your broker
- Automate with a script for daily calculation
Rank and Select ETFs
Rank all ETFs by IBS. Select the bottom decile (lowest IBS) for long positions and top decile (highest IBS) for short positions.
- With 20 ETFs: bottom 2 for longs, top 2 for shorts
- Alternative: use fixed thresholds (IBS < 0.2, > 0.8)
- Cross-sectional ranking is more robust
- Record your selections for tracking
Some days may have no extreme IBS readings. Consider skipping those days rather than forcing trades.
Execute Trades
Enter positions at or near the close (MOC orders) or at the next day's open. Exit the following day. This is an overnight-hold strategy.
- Use market-on-close (MOC) orders for entry
- Exit at next day's close or open
- Limit orders can save on spread but risk non-execution
- Factor in commission and spread costs
Track Performance
Monitor daily P&L, transaction costs, and win rate. The strategy should have a high win rate (~55-60%) with small average gains.
- Expected win rate: 55-60%
- Average daily return: 20-40 bps on winning days
- Track gross vs. net (after costs) returns
- Review if effect weakens over time
Broker Requirements
You need a broker that allows short selling (for long/short version) and has low commissions. Interactive Brokers is ideal for this strategy due to low costs and good execution. Consider commission-free brokers for long-only versions.
Helpful Tools & Resources
Strategy Variations
Explore different ways to implement this strategy, each with its own trade-offs and benefits.
Long-Only IBS
Only take long positions when IBS < 0.2. Avoids short-selling costs and restrictions. Lower returns but simpler execution.
Suitable for retirement accounts.
Multi-Day Hold
Extend the holding period to 2-3 days instead of overnight. Reduces turnover and transaction costs but may dilute the signal.
Balances signal strength with cost reduction.
IBS + RSI Filter
Combine IBS with RSI (Relative Strength Index) for confirmation. Only buy when both IBS < 0.2 AND RSI < 30. Reduces false signals.
Fewer trades but higher conviction.
Volatility-Weighted
Weight positions inversely by recent volatility. Low-volatility ETFs get larger positions. Improves risk-adjusted returns.
Reduces impact of volatile outliers.
Country ETF Rotation
Apply IBS specifically to country ETFs (EWJ, EWG, EWZ, etc.). Research shows strong IBS effect in international markets.
Diversifies across global markets.
Risks & Limitations
Daily trading generates high transaction costs. Spreads, commissions, and slippage can erode profits. Must use liquid ETFs and efficient execution.
IBS is a mean-reversion strategy. In strong trending markets, "oversold" ETFs may continue falling and "overbought" may continue rising. The strategy underperforms in trends.
Positions are held overnight and exposed to gap risk from news or events. A large adverse gap can wipe out many days of gains.
Some evidence suggests the IBS effect has weakened since ~2013 as more traders exploit it. The anomaly may be arbitraged away over time.
The long/short version requires borrowing shares. Some ETFs may be hard to borrow or have high borrow costs, reducing profitability.
Daily trading generates short-term capital gains taxed at ordinary income rates. Best suited for tax-advantaged accounts or traders with loss carryforwards.
References
- Pagonidis, A. (2013). The IBS Effect: Mean Reversion in Equity ETFs. NAAIM Wagner Award Paper [Link]
- Pandey, A., Pant, P., & Pant, A. (2023). Using Internal Bar Strength as a Key Indicator for Trading Country ETFs. arXiv preprint 2306.12434 [Link]
- Da, Z., Liu, Q., & Schaumburg, E. (2014). A Closer Look at the Short-Term Return Reversal. Review of Financial Studies, 27(3), 773-827 [Link]
- Nagel, S. (2012). Evaporating Liquidity. Review of Financial Studies, 25(7), 2005-2039 [Link]
ETF trading involves risk of loss. Mean-reversion strategies can experience significant losses in trending markets. Transaction costs significantly impact short-term trading strategies. Past performance does not guarantee future results. This is educational content, not investment advice.
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