Outfoxing Wall Street: Outfoxing Wall Street: How to conquer the markets with these 7 lines of machine learning code by Dan Murphy

Author:Dan Murphy [Murphy, Dan]
Language: eng
Format: epub
Published: 2023-03-14T22:00:00+00:00

Chapter 4:

Mean Reversion: A Complement to Trend Following

What is mean reversion and how it works

Mean reversion is a trading strategy that involves identifying when an asset or market is overbought or oversold and then making trades based on the expectation that the price will eventually revert back to its mean. This strategy assumes that the price of an asset will move back towards its average price over time, which means that traders can potentially profit by buying low and selling high.

Many successful traders have used mean reversion techniques to achieve significant profits. For example, Jim Simons, the founder of Renaissance Technologies, is one of the most successful traders in history, with an estimated net worth of over $23 billion. His trading strategies are based on a combination of mathematical models and mean reversion techniques.

Another successful trader who has used mean reversion techniques is Larry Hite, who co-founded the hedge fund Mint Investment Management. Hite's trading strategies are based on a combination of trend following and mean reversion techniques, which have helped him achieve average annual returns of over 30% for his funds.

The basic idea behind mean reversion is that prices tend to fluctuate around a central value, which is known as the mean or average price. When the price of an asset moves too far away from this average price, it is considered to be overbought or oversold. Traders who follow mean reversion techniques look for these opportunities to buy or sell an asset in order to capture profits as the price reverts back to its mean.

There are many different ways to implement mean reversion techniques, but one common approach is to use technical indicators to identify when an asset is overbought or oversold. For example, the Relative Strength Index (RSI) is a popular technical indicator that is used to identify when an asset is overbought or oversold. The RSI ranges from 0 to 100, and a reading above 70 is generally considered to be overbought, while a reading below 30 is considered to be oversold.

Traders who follow mean reversion techniques might use the RSI to identify opportunities to sell an asset that is overbought or buy an asset that is oversold. For example, if the RSI for a particular stock is above 70, a trader might sell the stock with the expectation that the price will eventually revert back to its mean. Similarly, if the RSI for a stock is below 30, a trader might buy the stock with the expectation that the price will eventually rebound.

Another (perhaps dated) approach to mean reversion is to use fundamental analysis to identify when an asset is overvalued or undervalued. For example, a trader might look at a company's price-to-earnings ratio (P/E ratio) to determine whether its stock is overvalued or undervalued relative to its peers. If the P/E ratio is higher than its historical average or the average P/E ratio for its industry, the stock might be considered overvalued and a trader might look to sell it.

Overall, mean reversion is a powerful trading strategy that can be used to capture profits in a wide range of markets.

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