Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average- Bob Farrell (https://www.investopedia.com/articles/fundamental-analysis/09/market-investor-axioms.asp)
Introducing Mean Reversion Trading
Determining just when price has been stretched too far from its average, and just how far back to the mean it may travel when it does revert, is at the heart of mean reversion. One wants to ideally trade this – meaning when the “too far” price begins to revert back to “mean”, one wants to execute a trade in the direction of the mean.
Mean reversion trading is a style that works on price action very differently and in most cases the opposite to momentum. To that extent, it takes a lot of nerve and guts to just apply it on a normal day. But those who do have come back with good reviews on this style of trading, especially intraday.
One requires a framework as well as a tool to comprehend and then execute this – this requires a tool that can help us – and that tool is readily available and in use for decades – called Bollinger Bands.
Using past price performance over X number of time intervals, this tool measures average or standard deviation from a moving average and draws bands on the chart, both above the below the average, that show the upper and lower limits of that deviation (that is, how much the rubber can stretch without breaking, so to speak). It is expected that price will stay contained within these bands going forward. This would be “normal” price action. Any move above or below the bands, therefore, signals an “abnormal” move beyond the standard deviation, hence an overextension that is likely to revert to the mean.
There are three components to the Bollinger Band indicator:
1) Moving Average: By default, a 20-period simple moving average is used. This is the mean!
2) Upper Band: The upper band is usually 2 standard deviations (calculated from 20-periods of closing data) above the moving average.
3) Lower Band: The lower band is usually 2 standard deviations below the moving average.
95% of all distribution in a sample set typically falls within 2 standard deviations, and the Bollinger Bands try to form trading signals based upon this mindset.
This probability based trading is is at the heart of the Mean Reversion strategy.
Reversion in Action
Looking at the chart, one can see that every time the market gets a bit over the Bollinger Bands, typically it tries to reach towards the middle red line as we go along.– This is mean reversion in action!
Bollinger Bands %B Indicator
Bollinger bands %B translates a portion of the price information in Bollinger bands into one line rather than the multiple bands you see with the standard indicator. Thus converting visual into quantitative numbers that you can use for building a system.
Percent B is intended to show where price is relative to each band and is calculated as: (Price – Lower Band) / (Upper Band – Lower Band). This is the starting point of the trading strategy.
A % B above 1 indicates the price is above the Upper Band and below 0 indicates below the lower band – at 0.5 it means the price is at the mean.
Creating a Trading Strategy – Playing the Bands
Playing the bands is based on the premise that the vast majority of all closing prices should be between the Bollinger Bands. That stated, then a stock’s price going outside the Bollinger Bands, which occurs very rarely, should not last and should “revert back to the mean”, which generally means the 20-period simple moving average. And if one is scared of derivatives, use ETFs as a way to test it out.
Given that there is a certain amount of risk in this trade, as one is betting for the opposite to happen, one may wish to minimize it by doing a lot of variations :
Potential Trade Setups
1) Instead of naked betting against momentum, one may wait and see if the price moves above or below the Bollinger Band and when the price closes back inside the Bollinger Band, then the potential trigger to buy or sell short would occur.
2) Use one more technical indicator to initiative these positions – this might prove beneficial when a trader decides whether or not to buy or sell in the direction of the breakout.
3) A tight distance between the top and bottom band may be indicative of a potential price breakout in one direction or another while a wide distance between the bands may indicate an upcoming period of relatively low volatility. One may wish to avoid very narrow volatility trades and wait till the bands expand sharply and begin to take rest so that mean reversion can happen smoothely.
4) Bollinger Bands adapt to volatility and thus are useful to options traders, especifically volatility traders. As they give a good idea of when options are relatively expensive (high volatility) or when options are relatively cheap (low volatility). When options are relatively cheap, buying options, such as a straddle or strangle, could potentially be a good options strategy. The reasoning is that after sharp moves, prices may stay in a trading range in order to rest. After prices have rested, such as periods when the Bollinger Bands are extremely close together, then prices may begin to move once again. When Volatility is high, selling options in the form of a straddle, strangle, or iron condor, might be a good options strategy to use.
5) Finally, we think its best to use it intraday as the newsflow means no fundamental shifts to the market and relative stability in the underlying assumptions. Smart traders may wish to use the 15 minute / 1 hour candles to create these strategies. Lesser may mean transactions costs will eat into profits and higher may mean too much interference with underlying markets.
Applying This Strategy
The visual trader may wish to use the PL Mobile App to create a study using these indicators (www.plindia.com/plmobileapp) and then create a SAVED VIEW to revisit all the scrips of choice during trading hours and initiate trades.
One may also use the trading terminals for such studies visually.
For quant traders, who want systems to generate these trades, PL offices and partners offer Fox Trader strategy terminals at select locations which may be used to create Algos and trade alerts.
For Non PL Clients, there are a lot of public websites available where one may visually create these charts etc or one may approach algo building companies to help them program and backtest these kinds of strategies.
Write to us at email@example.com if you need any information on this strategy or programming Fox Trader to do this for you.