Mean reversion Trading Systems DiscussionMar 16, 2021
A trading system in which a contrarian point of view is taken in the belief that market will return to normalcy or it's average or mean. A simple example would be the market has move rapidly fast or consistently in one direction and hence a correction to that move is imminent. So instead of taking the direction of the former market sentiment take an opposite view. The biggest challenge essentially is trying to time it and also if the market moves in one direction. SO lets break it down to factors that can weed out these problems
1. Speed - how fast did the market make the move. Is it higher than normal. The faster the move, the faster the reaction opposite. Think about tennis balls or Newtons 3rd Law of Motion
2. Time: Has the market gone down consecutively for the past n periods. the more periods the better likely for the market to see an opposite move.
3. News or Lack of news: A big move with characteristics mentioned above with no news gives more odds that an opposite move is likely.
Once these factors are taken into consideration then comes the trade management. The market can surely have events where it can move in one direction. hence the exits should be aggressive, Both from the stop loss side and from the take profit. The reason why we should be aggressive in the take profit side is that market can surely pullback or retrace and continue its pursuit, like the bouncing ball analogy. By exiting fast reduction of risk exposed will be drastically reduced. One of our strategies in the course we play around with our exits to optimize the best results and there has been scenarios when quicker exits provided better returns in backtest for the past 27 years.
The best performing hedge fund Renaissance Technologies trading system is a mean reversion system. the intricacies that we will never know. But we can surely build one of our own. But make sure to backtest optimize and even run a Monte Carla simulation to get the best out of your strategy