Tuesday, August 29, 2006

Trading By Mean Reversion

A number of good trade ideas can be generated from the concept of the market's average trading price. Rather than trend following, this can be considered trading by mean reversion.

Let's start with the average trading price from the previous day's trade. The volume-weighted average price is posted daily to the Trading Psychology Weblog. A simple alternative is the pivot point defined by the average of the day's high, low, and close price.

Since September, 2002 (N = 998 trading days), 70% of all trading sessions in SPY have revisited their prior day's average trading price (defined by the high/low/close mean). This 70% figure has remained constant since 2004.

It makes sense that an index such as the S&P 500 would retrace many of its moves. It is subject to considerable arbitrage and, as I pointed out in a prior post, has shown poor trending properties. Think of it this way: The Spooz have averaged a daily gain of around .03% for the past several years. The daily range of the index, however, has been around a full percent during this time. Clearly there must be considerable backing and filling: much noise surrounding the market trend.

Since September, 2002, 88% of all trading days have traded above their prior day's close, but only 54% have actually closed higher. 85% of market days trade below their previous day's close, but less than half have closed lower.

Trading by mean reversion becomes a powerful strategy when we realize that the 70% probability of mean reversion expands significantly when markets are losing volume (volatility) and when they are losing momentum. This is one important reason I track such indicators as the NYSE TICK and the volume at the bid/offer in my market updates. When we see buying or selling pressure wane after a market move toward a range extreme, the odds are greatly enhanced of a reversion to the mean of that range.

Note that this is a trading concept that is scalable by time. During 2006, for example, the odds of the afternoon ES market trading back to the average trading price of the morning are about 75%. Once again, when we see waning volume and buying/selling pressure in the morning, those odds go way up. Tracking order flow during short term price ranges can assist the trader in finding mean reversion scalps.

Traders who utilize the Market Profile framework should be quite familiar with the mean reversion trade. When we test edges of the value range and cannot facilitate trade at higher or lower levels, a move back toward the point of control is a high probability trade.

I daresay a disciplined trader could make a living simply trading this pattern.