In this issue:
Main Article
Using the "Dr. Stoxx Trend Trading Toolkit" to Trade Mean Reversions
Contributed by Dr. Thomas K. Carr
The Mean Reversion setup has impeccable credentials. Versions of it are used by some of the best known and most successful technical traders and analysts. It has been tested and back tested every way imaginable, proving itself profitable in all market conditions on all security types and derivatives. When the Mean Reversion system is done properly, there is no more exciting, more profitable, and yet more (nearly) mechanical trading system out there.
The key thesis of the Mean Reversion system is stocks that trade a statistically significant distance in price away from their mean, measured in our case by a moving average, tend, once a point of equilibrium is reached, to revert to that mean in short order. What we are adding to this thesis is that when we limit stocks that have travelled far from their mean to only those showing strong growth potential (for longs) or the lack thereof (for shorts), we improve our odds significantly of a successful reversion. This reversion is what we trade.
INTRODUCING THE SYSTEM
The Mean Reversion concept came into its maturity with market technician and financial analyst, John Bollinger (b. 1950). Bollinger swapped out Keltner Channels' use of ATR (Average True Range) for standard deviation (2.0). With this revision, Bollinger created trading bands that both envelop most of the price action over time, but are also dynamic enough to show changes in both volatility and directionality.
The Mean Reversion system I teach uses Bollinger Bands as its primary technical tool. On the longs side of the system, we are looking for stocks that have traded outside of the lower Bollinger Band, and which are trading significantly under their "mean" (the 20sma). I also apply a fundamental filter which favors those stocks that show strong earnings growth, low debt to equity, and recent institutional and/or insider buying.
On the shorts side of the system, we are looking for stocks that have traded outside of the upper Bollinger Band, and which are trading significantly above their "mean". Our fundamental filter on this side of the system looks earnings deceleration, and institutional and/or insider selling.
The Mean Reversion system detailed below is one I recommend you always trade in market-neutral pairs. This means for every long position you take you will need to find a short to mate it with; and for every dollar you have in that long, you should put a dollar into the matching short. The long/short pairs are treated as a single position: they are entered at the same time and exited at the same time. When done well, this system can hand you double digit monthly returns, and triple digit annual returns, regularly and reliably. The spreadsheet shown below (Figure 1) is my trading log for an eight week test (2012) of the system using a real-money account of $10,000. The average gain per week, including the losing weeks, was +3.3%. This is about in line with subsequent tests of the system. The total ROI was over 28%, or roughly +170% annualized with the compounding of gains.
TRADING THE MEAN REVERSION SYSTEM
Before you begin trading the Mean Reversion (MR) system, please remember that no claim is being made that following the step by step procedure as stated below will lead to profitable trading. It has in my case, but it may not in yours; nor in mine going forward. With that disclaimer out of the way, let's get down to work. Here are the tools needed to trade this system:
- Use MetaStock's "Dr. Stoxx Trend Trading Toolkit" if you do not want to program in your own scan. You will find both the long and short version of this system preprogrammed into the "Long + Short Mean Reversion Scan" in the TTTK add-on. With a single click of the mouse, you can scan the markets in real time for current MR setups.
- You will also need to bookmark the following website. We will be using this free service to perform a basic but very thorough fundamental analysis on whatever stocks pass our technical scan:
- Navellier's "Portfolio Grader" (Google the name and you'll get the URL)
RUNNING THE LONGS VERSION
STEP 1: Open MetaStock and go to the Power Console. Click on the "Explorer". Select "STTK - Long + Short Mean Reversion Scan." From the "Select List(s) to Explore" table, highlight "U.S. Optionable Stocks" or any other list you wish to scan. Click "Next", then click "Start Exploration". Make a watch list of charts for all passing candidates.
You should get 6 to 10 passing candidates each day. Since this scan targets price extremes, you will normally have more long candidates than shorts in downtrending markets, more short candidates than longs in uptrending markets, and fewer candidates of both sorts in less volatile markets. When the general market is itself outside the upper or lower Bollinger Band, you may get dozens of passing candidates come through the scan. In this case, it is best to modify the moving average filter. When you open the "Edit" function for the "STTK - Long + Short Mean Reversion Scan", you will see the following code line:
Simply change the "0.9" multiplier to 0.87 and run the scan again. Keep lowering the multiplier if needed until you attain a list of only 10 to 15 passing candidates.
STEP 2: Take your list of passing candidates and input them, one by one, into Navellier's "Portfolio Grader". When you do so, you will see 11 categories each with a grade ranging from "A" (best) to "F" (worst). There are three general categories: "Fundamental", "Quantitative" and "Total". We are only interested in the "Fundamental" grade.
Your best candidates for the long side of the MR system will show an "A" or "B" for its "Fundamental" grade. If you have a number of "A" and "B" candidates, give favor to those with the highest grades in the first four "growth" categories: "Sales Growth", "Operating Margin Growth", "Earnings Growth", and "Earnings Momentum". Two or more "A's" is a good indicator that we have a strong candidate for this system.
STEP 3: Do further discretionary analysis on any passing candidates from Steps 1 and 2. At the least, this should involve checking the headlines for any possible "deal breaker" story about each company. Stocks usually hit extreme prices for good reason, but these setbacks often provide trading opportunities as they bounce back to the mean. What we want to avoid in this important step is getting into any company that is experiencing systemic problems. These can include things like accounting scandals (remember WorldCom?), an unexpected FDA rejection, mines and wells that run dry, and so on. We want to avoid these things.
This system works best when traded in market-neutral fashion with long-short pairs. Thus once you have completed Step 3, you will want to run Steps 1, 2 and 3 for the shorts side of the system (simply reverse the "Portfolio Grader" requirement to favor stocks showing "D" or "F") and trade accordingly.
STEP 4 (position management): There are a number of ways to manage the paired positions in the MR system. The one that generates a higher win percentage is as follows:
- Exit any MR system long/short pair using a "Market on Close" order after 3 full trading days have passed since entry, if and only if either the long or the short position is trading at or beyond the 20sma (above the 20sma for the long, below for the short), or
- 10 trading days have passed since entry, whichever comes first
CHART EXAMPLES
Hawaiian Airlines, Inc., (HA) began as a regional airline back in 1929 with two small planes serving residents of the islands. Today it serves 8 million passengers a year who fly all over the Pacific Rim. Though hard hit in 2013, HA has been known as a strong growth stock with its acquisition of new planes, hubs, and destinations. It is also a prime study in Mean Reversion: it has signaled ten MR longs since January, 2009, eight of which were profitable. In the chart below (Figure 2), you will two of those signals straddling either side of a downtrend. Note that the MR system returned +20% going long over a period when the stock itself traded down:
Biolase, Inc., (BIOL) is a medical equipment maker that among other things makes dental lasers, pain treatment applications, and 3D imaging machines. The shares of the company, long the target of the momentum day trading crowd, have a way of getting ahead of themselves. Its chart looks like a silhouette of the Grand Tetons. Once these peaks reach equilibrium, where supply and demand match up evenly, it is time to put on the short position. The MR system is designed to catch these reversals of momentum. In the chart below (Figure 3), you will see three such shorting opportunities totaling over +38% ROI.
About the Author:
Aka "Dr. Stoxx", Dr. Thomas Carr is the founder and CEO of Befriend the Trend Trading, and author of two bestsellers: Trend Trading for a Living and Micro Trend Trading. He has been actively trading the markets since 1996 following several years of studying technical analysis. He is also the Founder and CEO of Kingdom Capital, LLC, and a General Partner of The 8:18 Fund, LP. He is the developer of the strategy used by the 8:18 Fund and is sole manager of the Fund's portfolios.
Dr. Carr earned Masters and Doctorate degrees in Philosophy from Oxford University (UK). He is a tenured Professor and has over 16 years of investment, trading and trader training experience. In 2002, he founded Befriend the Trend Trading, LLC, an investment advisory service offering three daily market letters and various trading seminars. He is also the author of two bestselling books, Trend Trading for a Living (McGraw-Hill, 2007) which has been translated into Korean and Chinese, and Micro-Trend Trading for Daily Income (McGraw-Hill, 2010). Dr. Carr has been interviewed by the Wall Street Journal and the US News and World Report for his expertise in market psychology. He also had a series of articles published in Stocks and Commodities Magazine.
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Support Tip
Where are the exploration options?
Contributed by MetaStock Support
In prior versions of MetaStock, the Explorer had two sets of options. One set was for all explorations and accessed from the Options button when viewing the list of available explorations. The other set was specific to each exploration and accessed from the Options button in the Exploration Editor. Both of these options screens have been combined in the current MetaStock. To access the Exploration Options:
1) Open the Power Console. (When you open MetaStock, the Power Console automatically opens for you.)
OR
2) Select the Explorer on the left side.
3) Select an exploration and click "next." For this example, we chose the "Equis - MSU-Rank" exploration.
4) Select any list(s) to explore and click "next."
5) You will now see the exploration options.
6) If you want to refine your exploration, do so here. Once you are satisfied with the set parameters, click "start exploration."
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Slauson's Slant on Trading
Forecasting with Grandpa's Trick Knee
Contributed by John Slauson
Since the late 19th century, weather forecasters have measured barometric pressure to predict the weather. The earliest barometers were invented in the 17th century. They were made of a basin of water and a glass tube. As the atmospheric pressure changed, the level of water in the tube fluctuated up and down. Since then, more accurate methods of measuring barometric pressure have emerged. Even so, my grandpa swore that changes in the pain level of his trick knee were more accurate than any of the fancy instruments used by meteorologists.
As technology has advanced, so has the reliability of weather forecasts. Forecasters have developed a wide assortment of new tools. They feed data into complex computer models that provide increasingly accurate forecasts. The key to their accuracy is using a wide variety of tools to analyze the data such as barometers, radar, satellites, and weather balloons. If their computer models were limited to data from a single tool like a weather balloon, then almost certainly their forecasts would be pretty dismal.
Forecasting the weather and forecasting the markets have many similarities. I learned an important principle from John Bollinger many years ago that I later used in the ICE add-on for MetaStock. Mr. Bollinger emphasizes the importance of avoiding technical indicators that have collinear variables. What does this mean? Here's how he explains it: "A cardinal rule for the successful use of technical analysis requires avoiding multi-collinearity amid indicators. Multi-collinearity is simply the multiple counting of the same information. The use of four different indicators all derived from the same series of closing prices to confirm each other is a perfect example."
In practical terms for MetaStock users wanting to build reliable trading systems, it means they should use indicators that measure a variety of market behaviors rather than many that measure the same behavior. For example, the two most popular technical indicators are RSI and Stochastics. With only slight variations, these two indicators are almost identical. The chart below shows a 14-day Stochastic and a 14-day RSI along with the correlation of the two in the top inner window. Note: the correlation coefficient is extremely high, ranging between 0.80 and 0.90. They are almost perfectly correlated. Even without using correlation, it is visually obvious that the two rise and fall in unison.
While two indicators being highly correlated (like RSI and Stochastics) does not necessarily mean they cannot be a valuable part of a trading system, in this case with the mathematical formulation underlying each indicator being so similar, you can be sure that there is little to be gained using both in the same system. So just like weather reporters, you should use a variety of different tools, not variations of the same tool.
One of the reasons we get sucked in to using collinear indicators is they optimize very well. The optimized results of a set of collinear indicators almost always show better historical performance than does a set of non-collinear indicators. Why? Because it is much easier to "curve fit" a system comprised of three highly correlated momentum indicators than a system comprised of different categories of indicators. A system that is curve fit to the past will rarely perform well in the future. Unfortunately you can't make money trading the past.
A better approach is to combine indicators that measure different dynamics such as momentum, trend, volume, and volatility. When building a trading system consider using indicators from at least three of these four categories. The table below shows some of the MetaStock indicators categorized into these four categories:
For example, RSI, Chaikin Money Flow, and Bollinger Bands when carefully combined into a system will provide non-collinear input that will likely perform better in the future. RSI measures momentum, Chaikin Money Flow measures strength using volume, and Bollinger Bands measure volatility.
And if you can figure out a way to work grandpa's trick knee into your system, then perhaps you will have found the holy grail!
About John Slauson
John Slauson began his career with MetaStock in 1988. In 2000, he left and started Adaptick, a company that provided training and developed popular MetaStock add-ons ICE, FIRE and PowerStrike. Over the years, he's worked closely with industry experts like John Bollinger, Steve Nison, John Murphy, and Greg Morris. In 2008 he returned to MetaStock as a Product Manager.
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MetaStock Power User Tip
Bollinger Bands - Part 3
Contributed by Breakaway Training Solutions
In this third and final video on using Bollinger Bands in MetaStock, Kevin Nelson will show you how to color-code your price bars when you get a Bollinger Band squeeze and how to get buy and sell signals when the prices break outside of the bands.
http://www.youtube.com/watch?v=eCYpebJ0LvY
For more MetaStock training, make sure to visit Breakaway Training Solutions at www.learnmetastock.com or email Breakaway Training Solutions at admin@breakawayts.com.
About Kevin Nelson
Kevin Nelson is the founder of Breakaway Training Solutions, Inc. He has spent the last 17 years becoming an expert on MetaStock software and a serious student of technical analysis while working for MetaStock. Prior to joining MetaStock in 1993, Kevin was a stockbroker for a well-known NYSE firm. In his role as Sales Manager at MetaStock, Kevin interacted extensively with MetaStock customers via phone, webinars, and public appearances. His experiences while working at MetaStock have enabled him to gain a keen understanding of the needs of technical analysts worldwide. While with MetaStock, Mr. Nelson was a featured presenter for four years. During this time, he traveled the U.S. introducing the MetaStock program to thousands of people and teaching them how to use its many features. His easy-to-understand approach is considered by many to be the best in the industry.
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