Mean reversion (MR) trading is a short term technique that takes advantage of a well-documented market anomaly whereby rapid short term price falls are often followed by a ‘reversion’ to the ‘mean’.
Mean reversion is a mathematical system that is also applied for stock trading and investing. The theory behind it is that a stock’s high and low prices are only temporary, and that a security’s price will tend to revert towards an average price over time. So stocks that dip down are likely to bounce back up.
Mean reversion is about identifying the trading range for a share, and then calculating the average price using fundamental data (assets, earnings..etc). Mean reversion may look to be a more scientific system of selecting share buy and sell points than charting, because exact numerical values are derived from historical data to identify the buy/sell values, rather than attempting to interpret stock market price movements using charts (charting, also referred to as technical analysis).
Of course mean reversion trading is not just as simple as buying any share that falls! If you do that, you will of course lose money! You will need to use filters that narrow the tradeable universe of shares down to those that are most likely to exhibit this momentum behaviour, and combine this with sensible risk management and exit criteria.
When the stock is trading at less than the average price, the security is considered attractive for entering a ‘buy trade’, the expectation being of course that the price will rise. When the present market price is above the stock’s average price, the stock’s tendency is to fall and revert back to the mean. So in a nutshell, deviations from the average stock price are expected to revert back to the average all other things being equal.
In this strategy, traders commonly use moving averages of 50 or 100 days to establish whether a stock has overshooted or is trading short of the mean. While reporting services provide the averages, identifying the high and low prices for the study period under consideration is still necessary.
This trading strategy offers a method of picking off high probability, short term trades that usually present themselves in times of extreme market volatility. The strategy is aimed at absolute performance; it will not hold your funds in the market for long periods of time. It is focused on short term, targeted, aggressive trades. As the strategy is volatility based it is unaffected by the general trend in the market at that point in time.
When using the reversion trading strategy to trade it is very important to be careful as large dips may imply a change of fundamental factors which may not revert back to a ‘mean’. This strategy is suitable for traders with a high risk tolerance, as trades are generally taken at times of high market volatility. Frequency of trades also tends to group around these times of market volatility; mean reversion is the type of system whereby you can truly call yourself a ‘trader’.
The strategy works on purchasing stocks that have been heavily oversold. Time and time again we see buyers return with strength to quality stocks that are oversold. Your aim as a mean reversion trader is to time your entry into the market so that you are in the stock and profiting from the rising prices that the returning investors create.
Brenton Hill’s Share Trading Story
Ten years ago Brenton Hill barely knew anything about share trading and since then he has quit his full-time job as a mechanical engineer to earn a living buying and selling shares.
In September 2003, the 37 year old embarked on an exploration to learn about trading shares. After less than two years share trading and a couple of weeks before his second child was born he quit his job and started trading full-time.
‘I had made enough from trading part-time for nearly two years to be confident I could trade for a living,’ Hill said.
Using a mechanical share trading approach Hill has grown his float by over 200%* in three years.
When Hill describes the secret to his success he explains, ‘The market is not out to get you it’s just the market. To be a successful mechanical trader it is important to divorce yourself from the daily happenings in the market so that you consistently follow your system.’
This is exactly what Hill did during the July and August 2008 share market correction which saw many traders say goodbye to thousands of dollars. Fortunately Hill was able to make money during this market tumble using mechanical share trading systems and sticking to his trading rules even when the market kept going down.
Hill said, ‘I gave back a fair chunk of my profit to the market in just one week and then regained this and more. I am well ahead again now.’
The trading style that Hill uses includes 12 systems which he trades in both the US market and on the ASX. The goal of some of these systems is to identify and buy falling stocks which have dropped significantly and are expected to rebound. This type of system is described as a mean reversion system.
‘Mean reversion trading is the revolution to making money quickly. One trade made me 74%* in two trading days, but those kinds of results don’t happen every week,’ said Hill. Hill tests the performance of each system using historical data from the past 10 years. He refers to this form of paper-trading as backtesting. ‘All of my systems would have performed successfully over the past 10 years according to my backtesting. These results give me confidence to trade shares in all market conditions. There are anxious moments but you must stick to your system rules to be successful,’ he said.
Hill trades both equities and Contracts For Difference (CFDs) and he stresses that a stock must have sufficient liquidity before taking the trade. Based in the Adelaide Hills, he explains that he never envisaged himself as a share trader and being at home with his young kids everyday.
Remember that CFDs are geared and can result in losses that exceed your initial deposit. They may not be suitable for everyone, so please make sure that you fully understand the risks involved.