Buying dips, pullbacks, and reversals with mean reversion trading strategies

Do you like buying stocks that are breaking out to new highs? Would you rather shop for a bargain after a market sell-off?

There’s no right or wrong answer, but there are important differences between the two approaches. The way we see it, every trading system can be labeled as one that either trades momentum or one that seeks out reversion to the mean opportunities.

Of course, there are also delta-neutral strategies, pairs trading, various option selling strategies, and other esoteric systems, but the far majority of trading systems, especially those executed by retail traders, fall into the camp of either fading a trend or extending the direction of a trend.

In this article, I want to talk about the good and bad attributes of mean-reversion trading strategies, clear up some common misconceptions about ‘buying the dip’, and look at some recent live trading data from our own trading system, Lamorak.
 

What is a reversion to the mean trading system?

Mean reversion strategies bet (by placing a trade in the opposite direction) against the prevailing market trend or recent move in the market.

Why would a trader want to bet against the recent trending move?

The logic behind these types of trading systems is based on the idea that stocks often get overextended or pushed too far in one direction in too short an amount of time and therefore get mispriced and are due to take a break or trade in the other direction.

Here’s an example of a mean-reversion trading system executing in an ideal environment of sideways movement.

Pretend you could determine a fair market ‘mean’ value for a given stock at all times, well any time a stock is far enough above or below your definition of fair value (mean) you would take a trade betting the stock moves back to that value.

The benefits of mean-reversion trading systems

The psychology of mean-reversion

When was the last time you were shopping for a new car or maybe some replacement appliances in your home? At one point or another, I’m sure you’ve looked at the listed price and thought to yourself, that’s too much money right now, let me wait to see if it goes on sale.

Waiting for sales and discounts is something we have been conditioned to do in our day-to-day shopping habits; however, when it comes to the stock market people seem to forget that cheaper prices can also be better. The stock market is one of the few places where people actually like to pay higher prices.

Why? Because news tends to focus on stocks that have already gone up in price and so FOMO dominates investors’ minds, thinking, well if this stock just went up 50%, maybe I can buy it now for the next 50%.

Read more: Reflexivity

Buying stocks that have less attention on them and which aren’t pricing in a lot of good news, can be a fantastic way to be early to a pending reversal and gain an edge as a trader.
 
The return profile of mean-reversion

This might not be intuitive for traders who haven’t studied these types of strategies, but what makes the profile of mean-reversion trading systems attractive is their high win rates. It’s not uncommon to see the percentage of trades resulting in a profit exceed 60% and sometimes reach as high as 70% or more. This is the exact opposite of many breakout or trend-following systems that typically have win rates somewhere in the 25 to 45% range.

Win rate trade statistics from Trade Risk’s two automated trading systems from 2006 to 2022

This is primarily due to the role of stop losses in mean reversion trading strategies (more on this later) but it’s also because of the core logic for entering and exiting trades. Mean reversion traders that buy dips for value tend to sell pretty quickly once the stock returns to what they deem ‘fair value’. This is much different than trend and momentum traders who are often looking for large trends with theoretically unlimited upside.

Sixty percent and 70% win rates sound great, don’t they? But we’re talking about highly efficient public markets, so there’s got to be a trade-off — and there is. We’ll take a look at some real trades and numbers in the next section.
 

Lamorak trading system results in June 2023

Lamorak is one of our in-house proprietary swing trading systems. It holds stocks for just a couple of days on average and it seeks to capture small gains in stocks that have moved too far and too fast in one direction by betting in the opposite direction. It is a classic mean-reversion trading system.

Here are the results of its trading for June 2, 2023 – June 30, 2023.

June 2023 was an exceptional month of performance, in fact, it was one of its best months in nearly 2 years for Lamorak. We’re not highlighting this month to talk about how great it did, rather, it’s to raise a magnifying glass on the distribution of trades, which we think is a more important lesson.

Here’s a snapshot of all the trades Lamorak took throughout June and the corresponding signal result:

Sorted from left to right, observe the percentage gain/loss on each signal Lamorak took in June. What you’ll quickly see stand out is the TSLA trade at -14.03% in the red. This isn’t a typo, the biggest gain/loss this month was TSLA and this type of distribution is what makes trading reversion to the mean trading systems so difficult.

Want the comfort of buying dips and a lot of small winners? Accept the occasional large loser

As you can see from our June trade log, the far majority of trades did result in a small win, however, the largest trade to stomach was a losing bet in Tesla. Putting some numbers to it, the average winning trade this month was +2.50% and TSLA was a -14.03% loser or 5.6x our average win size.

Why is this the case?

A well-constructed mean reversion trading strategy gets it right a lot of the time. It enters when stocks are stretched too far in one direction and then exits when the stock moves back into line with ‘fair value’. The problem of course is when a stock stretches, and then stretches more, and then stretches even more, and the mean-reversion trader gets hung out to dry.

We held an interview with quant researcher Cesar Alvarez where he drew the analogy to a rubber band getting stretched. Mean reversion traders are effectively playing for the rubber band to snap back, but occasionally, the rubber band might just snap altogether.  Read that interview here.

But Evan, just throw in a stop loss and don’t let TSLA decline that far

Great idea in theory, but it’s not that simple. Stop losses are effectively insurance premiums and paying for that type of insurance will significantly reduce the profitability of this type of trading system to the point where it may no longer generate any positive returns.

This is the trade-off you are accepting when you try and buy dips, pullbacks, and retracements.

Here are some actionable stock scans you can start using today to spot reversals and turning points from our TC2000 store:

Trader personalities that will do well with mean reversion strategies

It is pretty much engrained in all traders’ heads that you must have 2 times or 3 times reward-to-risk ratios in all of your trades. It’s in nearly every textbook, trading quote, and stock market guru’s pinned tweet that winners must be bigger.

Let me be very clear, I don’t think it’s ‘bad’ advice, and I do believe it can be an easier mindset for new traders to adopt, however, I do not agree that it’s a prerequisite in order to be a profitable trader.

You can be a very successful trader who has trade statistics more in line with 1 to 1 average-size winners to losers or even smaller average-sized winners, provided you’re closing profitable trades frequently enough. This brings us back to the top of the article, are you a breakout trader playing for trend continuation or are you buying dips for the stock to return to fair value?

Your mileage will vary greatly depending on where you fall.

Position size is crucial and so is taking every signal

On the surface, I’m sure it seems reckless to trade a system where the biggest results often come from losing positions. However, once you understand and accept that outsized losses are part of the distribution, this becomes an exercise of controlling risk through exposure and position size.

Should you be going all-in on any single trade? Absolutely not.

Should you invest every dime of your net worth in this trading system? Probably not.

When you understand that your next trade could result in a big loss, you’re more anti-fragile, you’re of a mindset that it can happen, and therefore, your risk management policies should have you prepared.

Flip the distribution around and pretend you’re trading a system that uses stop losses and has never run into big losers. You’re going to feel overly confident thinking just because you haven’t seen a big loser, you’ll never experience one in the future.

These are financial markets, we know that rogue waves do occur due to any number of reasons not limited to earnings, overnight company announcements, geopolitical events, war, etc. Traders who run strategies that don’t account for the dangerous left tail events are more susceptible of truly being knocked out due to their false sense of security around stop-losses.

Buying the dip is for more experienced traders

Reversion to the mean trading systems should be reserved for more experienced traders. They are for traders who understand the trade distribution profile they’re embarking on and they will act objectively and professionally in their signal-taking:

• They won’t pick and choose signals
• They won’t vary position size or get aggressive with specific signals
• They’ll always act on buy-and-sell orders and let their rules play out
• They accept up front they will need to sit through occasional much larger than anticipated dips

This list may feel small or trivial but each of these bullets offers up huge behavioral hurdles that most new traders wouldn’t be able to overcome.

Is mean reversion the right trading strategy for you?

There’s a lot of misinformation out there that can steer traders wrong:

• You can’t take trades unless you have a 3 to 1 reward to risk
• It’s too dangerous to buy dips in stocks
• You should always exit losers immediately

Like most blanket statements, context is required.

If you’re a trader with the right temperament and discipline, combined with the right rules and framework, then it’s perfectly okay not to follow those statements. Part of a trader’s job is recognizing what fits their strengths and beliefs and what can they stick with and implement flawlessly.

Hopefully, this lesson offered some new perspectives on a lesser talked about trading approach. For those who resonate with this style of trading, but may not be ready to tackle it on your own, check out our Lamorak Trading System and sign up for nightly Trade Reports to help you get started.

Good luck out there.