How I make $1000 in less than 7 days – Secrets of Mean Reversion

Mean Reversion is simply defined as — Returning to the mean.

Mean reversion trading in equities tries to capitalize on extreme changes in the pricing of a particular security, assuming that it will revert to its previous state.A mean-reverting strategy assumes any trends and moves will reverse and return to the mean. In statistics, this term is called regression to the mean.

Any data or observations that are on the tails of a normal distribution are most likely abnormalities that will sooner or later turn around a revert to the mean.

“Why does mean reversion trading work?”

If you look at most stock markets, you’ll notice it’s in a long-term downtrend.

Yes, we have recessions and bear markets along the way but, in the grand scheme of things, the stock market is making a series of higher highs and lows.

Why?

Because the stock market is a reflection of the economy.

Mean Reversion is the Opposite of Momentum

Momentum relies on the long tails that sustained trends provide and the goal is to ride those trends for as long as possible.

Mean reversion on the other hand relies on choppy random price action and preferably tight price tails so that price snaps back very quickly. If we review a trade distribution chart below, we can see where the two strategies generate their respective profits.

Mean reversion operates in the ‘noise’ where the majority of trades take place, whereas Momentum operates in the ‘outlier’ areas where not many trades occur.

Trend Following Strategy

Whenever the trend following strategy fails, mean reversion systems can prosper, specifically in a noisy, choppy market.

There is significant evidence to suggest that markets trend just 30% of the time, and therefore are directionless the other 70%.

Even in a stock market, which tends to have a long term upside bias, price action tends to be quite random. Over the last 10-years 1338 (52.9%) days were up and 1187 (46.9%) were down. The following chart of Microsoft ($MSFT) shows typical stock price action — rotation back and forth for 12-months before trending for about 3-months.

Do you know?

World’s Greatest Investor, Warren Buffett, is actually a Mean Reversion Investor. He buys companies well below their respective ‘fair value’ then waits for them to return to that valuation or higher. He will tend to only sell a company if it’s price rises well above it’s value.

Unfortunately two issues arise. Firstly, 99.5% of the population will not wait 10-years for a company to turn around and revert to its fair value. And secondly, he bases his decisions on pure fundamentals.

Psychologically for technical traders, it’s mentally difficult to follow this strategy because we need to adapt to catch the falling knife. But, when certain option strategies are applied, we can easily capitalize from it.

Mean Reversion Strategy (Rules)

Bollinger Bands is one of the most commonly applied technical indicators for mean reversion strategies.

These are generally useful when the price action inside the bands is considered ‘normal’, and action outside the bands is considered ‘abnormal.’

Price excursions beyond the bands tend to be reversed most of the time and they therefore lend themselves to being a good tool as a starting foundation.

#1: Bollinger Bands Extremes:

Identify when the price reaches one of the Bollinger band’s extremes.

#2: Stoch RSI:

Next, we need to define the depth of the pullback and we can use the Stoch RSI / Regular RSI (relative strength index) for it.

Here’s how…

When the 14-period RSI is above 70, it means there’s strong bullish momentum (over the last 14 days).

But as you know that currently the stock market is in a downtrend.

So by waiting for the 14-period RSI to be above 70, we can enter our trade at a “cheap price” and profit when the price reaches the mean.

#3: Momentum Exhaustion using TTM:

For the Mean reversion, we do the opposite of what Momentum shows.

For additional confluences, use TTM squeeze.

When the momentum is slowly changing, we can use this as a confluence and set up a trade.

#4: Exit when the 14-period Stoch RSI crosses below 30:

The idea behind this mean reversion trading is to capture “one move” in the market, and that’s it.

To define the “one move”, we can also use the 14-period Stoch RSI for it.

Does Mean Reversion work?

Yes, mean reversion works, but not in all markets. It works best for stocks and less for other financial assets (for example, FOREX/Crypto is more trending than mean-reverting).

You would have already been using Mean Reversion without knowing the concept of Mean Reversion. For example: RSI, Channels etc.

Is mean reversion profitable?

Most mean reversion strategies do operate with high win rates, 60% — 65%. Whereas trend systems operate at much lower win rates, 40% — 50%.

Drawbacks of Mean Reversion

You aim for a regression to the mean you sell or close the position after a moderate move in your desired direction. You cut the winners. Therefore, you must use specific strategies to benefit from this strategy.

I like to use debit spreads, as debit spread doesn’t require huge move to profit from the trade. To be profitable, it just needs to be above the breakeven price within the expiry.

Also mean-reversion strategies are not happy when it comes to stop-losses. Mean-reversion works better without stops, and thus you let the losers run.

Below are some of the wins using this strategy:

I teach the technicalities of it in my book Secrets of Credit Spreads where I go in depth on how I measure volatility, how I select strike prices, charting techniques, how to predict sentiment for next day etc. DM me on twitter if you need to 20% discount.

Bottom Line:

Although there are arguments against mean reversion trading strategies, many successful investors employed such an approach in the past and enjoyed a track record of success with it.

If you’re interested in other courses, you can check it out here.