Analysis of Backtested Buy and Sell Signals for the Top Three Mean Reversion Strategies
The three most effective strategies for mean reversion.
In this article, we will introduce three mean reversion strategies that are available at no cost. These strategies were previously shared on this website a couple of years ago, but we have made some slight modifications and will now showcase their performance on various ETFs. Additionally, we will explore the reasons why mean reversion is effective and identify the most suitable markets for implementing mean reversion trading strategies. We will also touch upon the topic of backtesting in historical contexts.
The concept of mean reversion, which was initially a statistical term introduced by Francis Galton, a renowned trader in the eyes of Victor Niederhoffer, has now become a financial term.
To begin, we will establish the definition of mean reversion:
Contents:
- The Concept of Mean Reversion Trading Explained
- Trading strategies based on mean reversion
- Comparison between Mean Reversion and Trend Following
- Why is mean reversion effective? Which markets exhibit the strongest mean reversion tendencies?
- Three strategies for mean reversion at no cost
The Concept of Mean Reversion Trading Explained
In both trading and statistics, the concept of mean reversion refers to the tendency of asset prices to fluctuate around a moving average over time. It is observed that abnormally high prices will eventually decrease, while abnormally low prices will eventually increase.
This chart provides a clear demonstration of mean reversion as a positive example.
The code for the ticker is SPY, and the blue line represents a trendline that has been drawn arbitrarily from the bottom to the upper right corner. However, it serves to demonstrate the concept of mean reversion.
The value of SPY fluctuates in a wave-like pattern as it gradually rises. It does not remain in one direction for extended periods of time before it “reverts” back.
Despite the bear market in 2008/09, the market experienced sudden reversals despite the overall downward trend.
In simple terms, the market always experiences interruptions in its direction. This can be compared to the natural cycle of ebb and flow.
It is quite surprising that the majority of mean reversion strategies tend to excel in a bear market.
Strategies for Swing Trading
Swing trading methodologies endeavor to harvest gains from transitory price variations over brief intervals. Markets ebb, markets surge. Occasionally, prices oscillate profoundly within a fleeting duration; at other times, they linger within a confined spectrum. Swing trading encapsulates this distinctive speculative style, focusing on short-term gains from these price swings.
Trading strategies based on mean reversion
Numerous trading strategies fall under the category of mean reversion, with the following being the most widely used:
- Indicators such as RSI, MACD, Stochastics, and Bollinger Bands are used to determine overbought and oversold conditions in trading.
- Market reversals are also commonly monitored.
- The concept of pullbacks is also considered in trading strategies, as demonstrated in this long-term pullback trading strategy for the S&P 500.
Trend-following is the antithesis of mean reversion.
Comparison between Mean Reversion and Trend Following
Mean reversion is the inverse of trend following. It typically results in a high percentage of small gains and occasional large losses, while trend following tends to have more losing trades but relies on infrequent significant gains.
As a result, there is a difference in the distribution of trades. Mean reversion tends to have a higher number of losing trades in the left tail, whereas trend following tends to have a higher number of winning trades in the right tail.
In previous articles, we have discussed:
Top 21 Strategies for Day Trading in 2024
Why is mean reversion effective? Which markets exhibit the strongest mean reversion tendencies?
Stocks are the most suitable market for mean reversion strategies, while they are not as effective in other markets such as commodities.
What is the reason for that?
The concept of mean reversion was not successful in the stock market prior to the 1990s. One of the contributing factors to this was the increased prevalence of futures trading, resulting in the exploitation of price discrepancies between stocks and futures contracts.
One of the factors contributing to mean reversion is the ongoing struggle between buyers and sellers. As the value of a stock increases, some individuals may be inclined to sell and profit from their gains, while others may be interested in shorting the stock. This results in a buildup of selling pressure.
In contrast, if a stock experiences a decrease in value, there will eventually be a surplus of buyers and the downward trend will come to a halt and possibly even reverse. Furthermore, individuals who have short positions may choose to secure their earnings by purchasing back their shares. This could explain the occurrence of numerous strong rallies in bear markets.
A bear market is the most suitable environment for mean reversion strategies to be effective.
Despite popular belief, our observation is that mean reversion is most effective in a declining stock market. This may seem counterintuitive, but the explanation lies in the heightened level of volatility. What may be even more surprising is that long positions are more advantageous than short positions.
During the period of 2008/09, we engaged in day trading and our profits primarily came from bullish positions, despite the market experiencing a decline of more than 50%.
The speed at which a bear market moves presents chances for investment. The grim outlook is quickly devalued, while a bull market, on the other hand, gradually increases in value over a period of time. The stock market tends to spend a considerably longer duration above the 200-day moving average compared to below it.
One significant aspect is that bear-market rallies are highly volatile.
Three strategies for mean reversion at no cost
We will showcase our complimentary methods for mean reversion. It should be noted that these strategies have been previously published, however, we have recently made some slight modifications to them.
Strategy for Mean Reversion: Deviating from a Recent High in XLP
The plan is implemented within the ETF named XLP, which represents the consumer staples sector. It was first introduced in 2013 and can be simply described as follows:
An initial investment of 100,000 has been compounded until the present day, resulting in satisfactory returns.
- Number of trades: 453
- Average profit per trade: 0.37%
- Compound annual growth rate (CAGR): 7.7% (equal to buy and hold strategy)
- Percentage of time spent in the market: 32%
- Maximum drawdown: 20%
- Profit factor: 1.8
Strategy 2: A mean reversion approach for shorting FXI using IBS
The Chinese ETF, FXI, has displayed significant mean reversion patterns over the past ten years. As a result, the following approach has proven to be successful:
- In case the current IBS value of (C-L)/(H-L) exceeds 0.9, it is recommended to short at the market close.
- The position should be closed at the end of the trading day if the IBS falls below 0.25.
An amount of 100,000 was borrowed in 2010 and then reinvested. This resulted in the following equity curve up until present day:
- Total trades: 224
- Average profit per trade: 0.63%
- Compound Annual Growth Rate (CAGR): 12.4% (compared to 3.3% for buy and hold)
- Percentage of time invested in the market: 34%
- Maximum loss: 12%
- Profitability factor: 1.75
Strategy 3 for mean reversion: Identifying a 5-day low in the S&P 500 index.
Strategy three is specifically designed for the S&P 500 index.
The approach was made public in 2012 and can be explained in simple terms as follows:
- In the event that today’s closing price falls below the five-day low from yesterday, initiate a long position at the closing bell.
- If the two-day relative strength index (RSI) closes above 50, sell at the close.
- If the sell criteria is not met, a time stop of five days will be implemented.
There is hardly a simpler option than this!
What has been the performance of this strategy? An initial investment of 100,000 in 1993 until present has resulted in the equity curve depicted below (the bottom graph shows the drawdown):
- Number of transactions: 448
- Average profit per transaction: 0.52%
- Compound Annual Growth Rate (CAGR): 8% (compared to 10.4% for buy and hold)
- Percentage of time active in the market: 16%
- Maximum loss experienced: 20%
- Profitability factor: 1.8
The approach is effective for the futures contract (of course), however, caution should be exercised regarding potential drawdown and leverage.
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Three mean reversion trading strategies that are free to use
In this article, it has been demonstrated that trading does not have to be complex in order to achieve favorable outcomes. The three mean reverting trading strategies discussed here, which are available at no cost, can provide a valuable starting point for traders.
Frequently Asked Questions:
What makes mean reversion a valuable trading strategy in the financial markets?
The concept of mean reversion is beneficial because it takes advantage of the natural fluctuations in market prices. This strategy operates under the belief that extreme increases or decreases will eventually return to the norm. Essentially, it exploits the idea that markets seldom move in a singular direction without undergoing corrections.
What are the most suitable markets for implementing mean reversion trading strategies and what is the reasoning behind it?
Stocks are the most suitable market for mean reversion strategies, while they may not be as effective in other markets such as commodities. This can be attributed to various factors such as the higher levels of volatility in stocks, the impact of futures trading, and the ongoing competition between buyers and sellers in the stock market.
What is the difference in performance of mean reversion strategies between a bull market and a bear market?
According to historical data, mean reversion strategies can be successful in both bullish and bearish markets. However, they tend to excel particularly in bear markets due to the accelerated pace of trading, resulting in more volatile trading days. This makes bear markets an ideal environment for implementing short-term mean reversion strategies.
