Mean reversion trading strategy (the rules)
The idea behind mean reversion trading is to identify stock markets in an uptrend, buy the pullback, and sell the rally.
Now, let’s transform this idea into concrete rules which you can use to trade the markets.
(Note: I didn’t come up with this trading strategy on my own. I learned it through the works of Larry Connor and Cesar Alvarez.)
- The market is above the 200-day moving average
- 10-period RSI is below 30
- Buy on the next day’s open
- Exit when the 10-period RSI crosses above 40 (or after 10 trading days)
Let me explain…
#1: The market is above the 200-day moving average
Now, even though the stock market is in a long-term uptrend, there are times when it’s in a bear market (or a recession).
In other words, we only want to be buying when times are “good” and stay on the sidelines during bear market conditions.
But how do we define “good times”?
Well, we can use the 200-day moving average as a trend filter.
If the price is above it, then we’ll conclude the market is in an uptrend.
If the price is below, then it’s a bear market and we’ll remain in cash.
#2: 10-period RSI is below 30
Next, we need to define the depth of the pullback and we can use the RSI (relative strength index) for it.
When the 10-period RSI is below 30, it means there’s strong bearish momentum (over the last 10 days).
But as you know, in the long run, the stock market is in an uptrend.
So by waiting for the 10-period RSI to be below 30, we can enter our trade at a “cheap price” and profit on the next upswing.
#3: Buy on the next day’s open
Here’s the thing:
If you want to know whether the RSI indicator has closed below 30, you’ll have to wait for the market to close.
This means the earliest time you can enter a trade is on the next day’s open—which is what we’re doing here.
#4: Exit when the 10-period RSI crosses above 40 (or after 10 trading days)
The idea behind this mean reversion trading is to capture “one move” in the market, and that’s it.
To define the “one move”, we can also use the 10-period RSI for it.
What we’re looking for is, for the 10-period RSI to cross above 40 which happens only after the market rallies higher.
Let’s have a look at a few examples so you can see how this mean reversion trading strategy works.
On 28th October 2020, the S&P 500 is above the 200-day moving average—which means you can look for buying opportunities.
Next, we check the 10-period RSI to see if it’s below 30.
And yes, it is! (Duh, I cherry-picked this chart.)
So, we enter at the market’s open on the 29th of October.
Then, we’ll wait for our exit signal which is for the 10-period RSI to cross above 40 or, after 10 trading days (whichever comes first).
In this case, the RSI crosses above 40 on 3rd November.
So, we exit our trade at the opening of the next day.
Now, even though this mean reversion trading strategy has a high winning rate, there will still be losers along the way.
So let’s have a look at one example that resulted in a loss…
On 25th February 2020, the S&P 500 is above the 200-day moving average.
Next, we check if the 10-period RSI is below 30—and it is.
So, we’ll go long on the next day when the market opens.
On 5th March 2020, the RSI crosses above 40 which is our exit signal.
This means we’ll need to exit our trade on the next day (when the market opens).
Unfortunately, the market gapped against us and this resulted in a loss.
At this point:
You probably have questions like…
“Can I use a 14-period RSI for entry signal?”
“Can I exit when the RSI cross above 70?”
“Can I use a trailing stop loss instead?”
Well, I’ll tell you more later in the FAQ section.
For now, let’s analyze the results of this mean reversion trading strategy…