Price shifts are hard to understand, and finding a good trading strategy is difficult for many traders to reach some kind of constancy in profitability. Markets are hard to read without a basis of knowledge regarding market behavior.
Therefore, mean reversion trading strategies realize power to benefit from deviations in price from historical averages. The principles of mean reversion help the trader make valid judgments about when to buy an oversold and sell an overbought asset.
In this article, we will introduce three successful strategies of mean reversion trading, that you are free to test yourself. We will look into why mean reversion is a powerful strategy, which markets are optimal to apply them, and provide historical backtesting results to demonstrate their potential performance. Enjoy reading and improving your toolkit!
What is Mean Reversion?
The trading strategy of mean reversion is based upon the fact that asset prices have a tendency to revert to their historical average over time. The larger the departure of an asset’s price from its mean, the more likely that asset’s price will revert to that average. For a trader, this means buying the assets that are currently oversold and selling those overbought.
Why It Works
While one can speculate on many factors that are tougher to identify, the presence of program trading as a factor is one of the obvious influences. Algorithmic traders are known to push prices back toward their mean every time there is a price deviation, and this mostly amplifies the effects of the phenomenon called mean reversion.
Strategy 1: Consumer Staples Mean Reversion
Market: Consumer Staples ETF (XLP)
Trading Rules:
- Buy: After a huge decline in the market.
- Sell: When the market turns strong.
First published in 2013, this strategy has delivered the same results consistently each year. Starting the investment with just $10,000 since the inception would have generated 457 trades with an average return of 0.38% per trade and annual returns of 6.7%. It is close to a buy-and-hold performance of 6.8% during which the strategy invested just 28% of its time. The return-adjusted risk is 23.6%.
Performance Highlights
- All Trades: 457
- Average Return per Trade: 0.38%
- Annual Returns: 6.7%
- Max Drawdown: Minimal, due to the conservative nature of consumer staples.
Strategy 2: Chinese Market Short Strategy
Market: Chinese Markets (FXI)
Trading Rules:
- Sell Short: When the IBS indicator shows that a state of overbought has occurred.
This strategy, based on the FXI ETF, uses the Internal Bar Strength (IBS) signal to detect over-bought conditions. Although it shows excellent mean reversion tendencies over a decade now, the strategy is, by its nature, somewhat more sophisticated because of the problem of short selling.
Key Performance Highlights
- Annual Returns: Greatest performance compared to any buy-and-hold strategy.
- Market Diversification: A perfect balancing act in portfolios against long strategies.
Critical Considerations
Because short strategies are likely to be biased upward in the stock market, even if they hold great potential return, the trader needs to be aware and handle risk.
Strategy 3: S&P 500 Mean Reversion
Market: S&P 500 ETF (SPY)
Trading Rules:
Buy: When the S&P 500 makes a five-day low.
Sell
Closing price is more than the previous day’s high or after five trading days.
This long strategy has been effective since the book got published in 2012. Given a base investment amount of $10,000, it has shown average annual returns of 8.8% whereas the buy-and-hold return stands at 9.5%. This is more important as this strategy spent only 19% of time in the market and thus reduces the risk factor.
Performance Headlines
Annual Returns: 8.8%
- Investment Time: Only 19%.
- Drawdown: Small due to low market exposure.
When Is It Most Effective To Use Mean Reversion?
Backtest shows that the mean reversion strategy is best during bear markets. In a sense paradoxical, higher volatility in downturns pushes prices out of balance by greater extent which means more likely that it will come back to a more balanced state through mean reversion, albeit with higher amplitude.
Summary Effectiveness of Mean Reversion
- Long Strategies: Typically work better than short strategies.
- Volatility: The noisiest the market, the more likely a mean reversion trade is possible.
- Market Conditions: Bear markets sometimes make mean reversion trading more profitable.
Conclusion
Mean reversion trade strategies are one of the many ways a trader would use price moves to gain an advantage. The three above demonstrate the applicability of mean reversion in different environments: consumer staples, the Chinese market, and the S&P 500.
While every trading strategy comes with some form of risk, this has been a viable option, especially when the market conditions really go shaken. With significant historical performance and strong returns even adjusted for risk, these strategies could take your trading game to the next level.
If you are interested in having all the codes behind these strategies, you should join the ranks as an ex-member for the exclusive access, of course. Remember, however, that in trading: understanding what makes this market tick is something you should know for long-term success. Happy trading!