Today, you’ll learn why reversion to the mean works.
- What is a reversion to the mean?
- Mean reversion indicator
- Example strategy
Reversion to the mean does work because of profit-taking.
Generally, profit-taking happens when the stock price is far from the average price. When the price is 50% away from the mean, traders often take their profits.
This could result in the retracement of price to the mean.
The mean is likened to a price magnet that stops the price from moving farther away.
Technicians and fundamentals use this information to their advantage.
The advantage can be buying and selling oversold and overbought stocks.
Oversold stocks to traders mean a possible reversion to the mean trade.
The mean or average is a trader’s reference point.
The reference points are usually 20, 50, 100 and 200 moving average.
The moving average is one of the tools that are popular to short-term traders.
Short-term traders may use only 50, 20, or less moving average settings, while more than 100 are for long-term traders.
What is a reversion to the mean?
According to Investopedia, “Reversion to the mean involves retracing any condition back to the previous state.” (source)
The state can be the average price or trend of the stock.
If it is too far from the mean, the price will usually retrace back to the mean.
But, on an uptrend, it is the same with extreme changes.
For example, a higher high may retrace to its previous higher high.
The retracement can be more or less 50%.
Fibonacci Retracement tool is a tool for traders to measure the expected retracement.
Traders use the tool to find confluence with support and resistance.
Confluence is a technique which combine more than one trading technique.
For example, the stock price is at support and is at 50% Fibonacci retracement.
In this case, the price will most likely revert to the longer-term trend.
The trend could be up or down.
In an uptrend, most traders buy the stock when the price is too far below the mean.
The distance is often 50% or more from the mean.
50% or more are already extreme in most cases, unless there is a market crash.
Profit taking is the reason why the stock price reverts to the mean. The price reverts because people are selling when the price is away from the average.
When the price is far from the mean, the risk becomes greater and fear will come in.
Fear is the number one reason why stock prices do not move in straight line.
Stock prices move in a zig-zag pattern because of profit-taking. The zig-zag pattern is known as higher highs and higher lows in an uptrend market.
In an uptrend market, the price often retrace to the mean.
These retracements offers trade opportunities for technicians and fundamentals.
Technicians use technical indicators to try to predict where people might close out their stock positions.
The closing out of stock positions often causes the stock price to change direction.
The change of direction is called the reversal which technicians are always monitoring.
Mean reversion technicians try to predict these price behaviors to make money in the stock market.
To make money, they need to understand fear and excitement in trading.
The fear of beginners is the most important target to be successful in stock trading.
It is important because it it predictable.
For example, novice traders often average down their losing trades and cut their winners short.
They cut their losses around 3% to 10% because they cannot hold their winning trades that long.
Because they cannot hold their positions mean reversion traders can push the stock price in the opposite direction.
Pushing the price in the opposite direction will force the beginners to average down or up which makes reversion to the mean profitable.
To be profitable, traders can also watch for institutional traders around mean reversion areas.
To uncover institutional traders’ transactions, professionals often remove block and cross trades.
Mean reversion indicator
The Relative Strength Index is the most popular indicator for mean reversion.
It is popular because it is widely available for most trading platforms.
Although it is widely used, most traders fail to use this indicator.
Failure often happens because most beginners use the default setting.
The default setting is the 14-period which does not have an edge in the stock market.
The edge comes when the period is changed lower or higher.
In this website, lower period is better based on our Amibroker test.
The test was done through a cumulative RSI which is available on the strategy link above.
The RSI is a good tool to predict momentum and reversal areas in a stock chart.
Reversal areas are easily detected when 2-period is used and the value is below 5.
The value is the sum of the two-day-period RSI.
The video above shows an example of a reversion to the mean strategy that works.
It works because it was tested in a certain stock exchange. Testing must be done first before using in an actual trading environment.
In the actual trading environment, for example, NASDAQ, traders should test this strategy.