In a previous article on Pairs Trading , we had talked about a concept called Mean Reversion (https://www.plindia.com/blog/what-is-pairs-trading/) and how to profit from it. Mean reversion suggests that asset prices eventually return back to the long-run mean or average of the entire dataset. This mean or average can be the historical average of the price or return- like the 200 Day Moving Average, or another relevant average such as the growth in earnings ensuring that markets return to an equilibrium long term PE Ratio.
Using the Mean Reversion Theory
The mean reversion theory is used as part of a statistical analysis of market conditions, and can be part of an overall trading strategy. It applies well to the ideas of buying low and selling high, by hoping to identify abnormal activity that will, theoretically, revert to a normal pattern.
Nifty Mean Reversion Trading
A) The Chart
The chart below shows the following
- The maroon areas shows the spread of the Nifty versus the 200 DMA on daily basis (Nifty Close less than 200 DMA) since December 21, 2011 till December 21,2018- a 7 year period.
- The Blue line shows the Nifty movement
- The 6 horizonal lines show various extremes which we shall explain below
The chart clearly shows how the price stayed almost always above the 200 DMA (Maroon area remained positive) in the left half of the chart and the upside momentum in Nifty continued. Then there was a down drift in the Nifty that got arrested in 2014 once Modi came to power and thus began the next upward move to 11700 levels. At the time of writing this blog we finished at almost 200 DMA (Spot Close 10754 vs 200 DMA 10764).
Observe the horizontal lines carefully – especially the 1st one on top and the last one at the bottom, titled Overoptimism and Depression- These occur typically when the Nifty has gone either side of the 200 DMA by 1000 points. Then observe the second and the fifth- around 500 point deviations and finally the third and the fourth, which are observed around 250 levels.
b) The Visual Observation
One can see that the extreme lines occur and then start disappearing – this means that the difference between the 200 DMA and the actual price starts to close at a rapid speed after the extreme is observed. This could happen either because the market consolidates slowly – with or without range – or falls sharply allowing the 200 DMA to catch up which corrects this gap. Either way, one thing is clear – These are extreme readings which may disappear.
Moving on, one can see a similar behaviour for the second and fifth lines – the 500 point difference between the actual Nifty and the 200 DMA comes and then goes away rapidly.
The third and fourth lines, the ones that indicate the 250 point moves from 200 DMA, are much more frequent – showing indecision around the 200 DMA and constant occurence of this phenomenon.
c) The 200 DMA Switch
We all know that one needs to switch off from markets once the price falls below the 200 DMA – indicated by the Maroonish area turning negative.
The question however is when to re-enter AFTER large falls as well as when to exit AFTER A LARGE RISE.
This is where the mean reversion theory comes to help.
Rules to determine entry /exit points
A simple observation shows that each long term trend, upward or downward, an extreme reading happens followed thereafter by price behavior that causes the resumption of an opposite trend. While the math around this is proprietary to PL , suffice it to say that the following rules may help approach markets with a bit of better accuracy and science and the validity of such rules may be checked visually
RULES TO TRADE
- +/- 250 Points around 200 DMA – Stay away from Nifty as the trend may change. Have very light positions. Get into Buy or sell only once this first boundary is breached either side.
- If the market is between +250 and +500 points away and trending higher, buy into ETFs. If the market is trending lower and is in a -250 to -500 point zone, buy Puts on your portfolio holdings
- If the market is rising and is in the + 500 : +1000 point zone, bulk up on midcaps or build leverage. If the market is falling and is in the -500 to -1000 point zone, continue with Puts and sell calls.
- Finally, if the market has fallen to more than a -1000 point difference on the downside, look for the first move into the 500 point range (may happen either if price rises or if markets slowly grind down) to start buying ETFs OR buy out of the money calls. This is contrarian buying. If the market has risen to a more than +1000 point difference, start becoming cautious and wait for the first move to below a 500 point difference which may be a turning point (Again contrarian). Buy Puts.
- As soon as the first ranges are reached, 250 points to Zero, become light.
LATHER – RINSE – REPEAT!
Now try practising these rules against the chart above! See what happens especially during each long term trend.
See also what happened recently when we fell from a high of almost 11700 to 9500 levels – and the extreme deviation went to 800 points – would you have bought?