Rubber Bands (Mean Reversion Trading)

Pull back that price and then let go!
Pull back that price and then let go!

A couple¬†of days ago I mentioned (here) that I had sold a couple of profitable stocks and was going shopping for more, as part of a discussion on the folly of a “buy and hold” strategy. After yesterday’s big tumble you’re probably thinking, “what, is he an idiot?” Or perhaps just shaking your head at my bad luck.

Well, not to fear! What I didn’t mention was that I was concerned the market was going to take a dive shortly. I have a market-breadth indicator inspired by the one Pradeep Bonde of stockbee uses. Three days ago the indicator went “beep!” (Metaphorically speaking.) This told me I needed to a) take profits on a few swing-trade stocks I had going, and b) prepare to go shopping for some mean-reversion plays when the market took a dive.

Then the next day the indicator went back to normal. Hmm. Was it a false alarm? Probably not, but I decided not to blog about it since a) I’m not in the prediction game and b) I don’t like to look stupid when I make incorrect predictions. I did however tell my 12 year old son, “son, the market is going to fall¬†significantly in the next few days” (pretend you can hear me using my deep ‘Dad’ voice as you read that).

Yesterday I got to show him how amazing I am. Super Stock Dad as far as he’s concerned. Because sure enough, yesterday the market tripped over its own shoelaces and landed face down in the mud. I locked in some profit on a couple of trades, and bought another stock at the close after it had fallen significantly.

Basically there are two types of short-term trades: momentum trades and mean-reversion trades. Pradeep is a big fan on the momentum trade: when a stock has been moving up and then takes a breather, be prepared for when it shoots up again to make a quick profit.

Howard Bandy is more of a mean-reversion kind of guy. Mean reversion is the term for when a stock’s price moves abnormally far in a particular direction, and you catch it at the furthest extension from the ‘mean’ (i.e. the average the price was hanging around before) and ride it as it snaps back. Just like a rubber band.

When you yank that rubber band way back, the big question is whether it’s attached to something or not. If there’s no snap-back, then you just have momentum in the wrong direction!

In my many hours spent backtesting various systems and ideas, I have had very little luck with momentum systems so far. However, the mean-reversion systems are lookin’ tight, yo! In fact, my Band-to-Band system for which I sometimes post signals is basically a mean-reversion system, incorporating a confirmation signal. I’ve come up with some other systems that also look good, and that was what I traded at yesterday’s close.

Some momentum plays just never take off, and head the wrong direction. Some mean-reversion plays don’t bounce back, and keep heading the wrong direction. That’s just how it goes. Here’s hoping my rubber bands are attached at the other end.

 

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