Today, you’ll learn how to detect mean reversion?
Steps to detect mean reversion:
- Start by Making a Chart of the Data for Analysis
- Use the Average Value as Your Reversion Point
- Look for Patterns in The Data, such as Peaks or Deep Pointed Dips
- Create Additional Charts to Help You Understand The Results Better
- Determine If There are Cycles in Price Movement
What is Mean Reversion?
Mean Reversion is the tendency for a trading or investment portfolio to return to its average level after a period of being over- or undervalued.
According to Warrior Trading, trading the mean reversion is difficult considering that it is like buying falling knifes and rising securities. (source)
So, it is better to trade in a strong trend and not get smashed in a Range type of market environment.
However, traders may need to use mean reversions strategies to time buy and sell correctly.
For example, in an up moving market, it is an excellent strategy to buy on a pullback and mean reversion can help people identify when execute a trade.
Many indicators are available on different charting platforms which can detect reversion to the mean.
1. Start by making a chart of the data for Analysis
The first step is plotting the stock data on the chart to create visualize all the data points.
As an example, traders can use free charts of Trading View and other online chart platforms.
For more advance analysis, the recommended tools can be Amibroker, R Language or Python.
However, the last two are programming language which require extensive knowledge.
While Amibroker is easy to use for trading, back-testing and optimizing, the downside is it is expensive.
Yet, traders can use the software for as long as they need it after payment.
2. Use the average value as your reversion point
The most common method of detecting mean reversion is calculating the mean of the price movements.
For example, traders usually add the Simple Moving Average indicator in the chart to understand how the price moves relative to the period.
A moving average is a simple calculation which includes taking the closing price of the last few days and dividing this by the number of time periods. This gives you a clear sign of which direction the movement has been.
However, when the price often returns to the mean or average, mean reversion probably exists.
Notice how the price usually returns to the mean every time the price has gone too far.
3. Look for patterns in the data, such as peaks or deep pointed dips
Using mean reversion indicators is also a useful process to detect mean reversion.
For example, by adding MACD or RSI in the chart, traders can observe how the price moves back-and-forth.
When the MACD is at the oversold levels and the price rises thereafter, mean reversion is currently active.
If there is a mean reversion, traders can also look for trading opportunities.
Trading opportunities are not only about looking at trend-lines but also about looking for confirmation.
Let us say the stock price is at the support line, and MACD is below 30, often, it is a sign that mean reversion exists.
However, there is no guarantee that the price will move to the mean.
4. Create additional charts to help you understand the results better
Another method to detect mean reversion is through correlation.
For example, in a Financial Sector of a Stock Exchange, stock prices of banks may move in the same manner.
Bank 1 may correlate with bank two.
There is one strategy used by most hedge funds that may help generate huge returns year after year.
The returns are excellent given that the strategy is at the low-risk category.
Here are the rules of the strategy:
- Deduct the lowest stock price from the higher price stock.
- Remember, both stocks must have strong correlation.
- Plot the stock into the charts.
- Apply Bollinger bands to detect mean reversion.
- When the chart crosses the bands (Top or Bottom), buy the first and sell the second stock or vice versa.
To apply the strategy above, traders can not use the above steps unless they have a good charting tool.
Free charting tools can not do the customization above because it is not available.
However, it is simple to code the strategy in Amibroker.
Stock1="BPI"; //must always have higher price Stock2="MBT"; Pair=Foreign( Stock1, "Close" )-Foreign( Stock2, "Close" ) ; Plot(Pair, "BPI-MBT",colorBlue,styleline); _SECTION_BEGIN("Bollinger Bands"); P = ParamField("Price field",-1); Periods = Param("Periods", 15, 2, 300, 1 ); Width = Param("Width", 2, 0, 10, 0.05 ); Color = ParamColor("Color", colorCycle ); Style = ParamStyle("Style"); Plot( BBandTop( P, Periods, Width ), "BBTop" + _PARAM_VALUES(), Color, Style ); Plot( BBandBot( P, Periods, Width ), "BBBot" + _PARAM_VALUES(), Color, Style ); _SECTION_END();
Advance traders use tools to help them understand the price action of a stock, so they can make the best decision on a particular trading day.
5. Determine if there are cycles in price movement
A price cycle is a repetitive pattern observed in the movement of prices.
Several cycles exist:
- Bull market and bear market cycles: Bull and bear markets describe the short-term movements in stock prices.
- Economic cycles: Economic cycles are long-term fluctuations in business activity, often tied to larger economic trends such as the business cycle.
By observing different cycles, traders can detect mean reversion.
In the first step above, traders can use free and premium tools. When the chart resembles a sideway market, the stock is probably moving just inside the range.
Chances are high, the price of the stock may return inside the range if it is too far from what is average or normal.
As a general rule, there are five ways to detect mean reversion in this post. However, it is important to master one strategy to have room for improvements every day. One of my favorite, number four, because it is useful for my daily trading.
Did you learn something new about our post, “How to detect mean reversion?”
Please share it.