In this article I will explain how I started trading mean reversion trading strategies and their benefits, for you to consider adding it to your portfolio. But before that consider following scenarios…
How many times have you seen the stock hitting your stop loss and turning out to be a hugely profitable trade ?
Have you observed that whenever there are too many analysts on TV bullish or bearish on a particular stock and the opposite happens ?
How many times you have experienced that whenever risk management department of a broking firm squares off someones stocks, it immediately rises ?
I have observed that whenever I put out very bearish or bullish view, markets usually makes a short term bottom. I have seen scenarios like these play out so many times in 15 years of my career. Why does it happen ?
What is Mean Reversion ?
Well, it happens because of human emotions of fear & greed. People tend to get fearful & panic when the stock goes down & become overconfident & greedy when prices are going up. These emotions creates a short term mis-pricing in securities. Smart money comes in, supports the price and the stock rises for a couple of days. This behavior is called Mean Reversion. It can also be called Swing Trading or Pullback Trading. Warren Buffett aptly describes this behavior in his quote…
“Be Fearful when others are greedy & be Greedy when others are fearful.”
Have a look at the below chart to better understand what mean reversion is…
But I didn’t know this behavior had a name back in 2011 when I was working for Kotak Securities. I was a budding technical analyst truly believing in the stop losses. I had a colleague there who used to buy stock when they had fallen down a lot. Whenever we bought the stock, I used to follow stop loss religiously. On many occasions, when I used to get out for a small loss, I used to think that my colleague has screwed up by not keeping the stop loss & he is going to suffer a huge loss. By mid-day, he would have a loss, 2-3 times bigger than mine. I used to be happy that I played smart.
But to my dismay, by the end of the day, the stock had completely wiped out the loss & turned in profit !!!
What the heck just happened ? Now I was not happy that I sold off the stock in loss while he sold in profits !!!
Although many times he used to get hit hard but more often than not, he would turn out to be a winner. He had no formal plan or strategy per se. But this intrigued me & I started digging further as to why this happens.
After a couple of months, I came across tradingmarkets.com & Larry Connors research. I was immediately hooked as I could see that he was talking about the same behavior that I was searching. I read tradingmarkets.com blog twice all the way upto 1999. I read all his books and bought many courses. I have been trading quantitative mean reversion strategies ever since.
Why Mean Reversion trading strategies?
I started to apply some of the strategies I learnt from Larry Connors. These mean reversion strategies had another benefit as far as my job was concerned.
Since I was working for a brokerage firm, my primary job was to generate brokerage. Now brokerage can only be generated if a lot of clients churn their money. With these strategies I was able to balance both revenue generation as well as client profitability & I was doing pretty good.
Hybrid Model
Fast forward to 2018, I had developed my own trading strategy based on Larry Connors concepts. The strategy I trade currently is very conservative and has a very low exposure to markets. Now when there are no trades, the cash was lying idle & it was not yielding anything. I realised why not put the cash to work by investing into top quality blue chip stocks. If there are any opportunities from my system, I can always take leverage to apply my system.
I backtested many portfolio combinations & it turned out to be great. I learnt that the long term portfolio will only appreciate when there is a broader uptrend in the market. While my mean reversion strategies will excel in a corrective or sideways markets. This is a marriage made in heaven !
Benefits of Mean Reversion strategies:
1. Diversification:
It provides an excellent diversification to your long term investments which is usually dependent on long term trends in the market. Both the strategies have a very low correlation to each other. Diversifying your portfolio into non-correlated strategies is the Holy Grail of Investing according to Billionaire Hedge Fund Manager Ray Dalio because it significantly increases the risk-adjusted returns.
2. Additional Returns on your existing portfolio:
If you have an existing portfolio of stocks, you can apply mean reversion strategy to earn extra returns. You can take conservative leverage on your portfolio and improve your returns with same or less risk.
3. Any type of market condition:
Beyond the benefits of flexibility and maneuverability, mean reversion strategy is advantageous because it allows you to trade the market regardless of whether it’s up, down, or even sideways.
4. Short term trades lasting 5-7 days:
The less time you are in the markets, the more you are immune to price shocks. The objective of mean reversion strategies is to buy a stock when there is a great deal of fear & exit quickly when the fear subsides.
5. High number of winners:
High number of winners helps us to apply the strategy consistently. These kind of strategies typically have a win rate of more than 65%.
6. Low Drawdown:
Lower drawdowns helps us to achieve smother equity growth over a period of time. You can reduce your long term investment portfolio drawdown with mean reversion strategy.
7. Flexibility:
This type of trading does not require you to be seated in front of the a computer for the whole day. You can prepare the list of stocks the night before or just before the markets closes, place orders and you are done for the day. You can continue with your job or business.
