Mean Reversion and Trading Strategies for Stocks and ETFs

To keep things simple, you should view reversion to the mean in the following order as to how well each group has historically moved higher from oversold conditions above the 200 day and lower from overbought conditions below the 200 day.

I’ll include stocks in this group as the benchmark and as a point of reference for the ETFs. This information is not set in stone but it is based upon looking at millions of stock trades and tens of thousands of ETF trades going back as many as 15 years.

In reverse order:

4. Stocks: Stocks revert to their mean on a short term basis but less so than ET’s. What this means is that you want to see stocks extremely oversold (above the 200 day) before buying, and extremely overbought (below the 200 day before shorting.

3. Commodity and Currency ETFs: Commodity and Currency ETFs require a greater stretch than other ETFs as they tend to historically have a trending component to them. They don’t need to be as stretched as stocks, but they should be more stretched than other ETFs.

2. Sector ETFs: Sector ETFs are very good vehicles to trade using proper overbought and oversold indicators and the proper exit (for this conversation we’ll define that proper exit as a cross above/below the 5 day ma). You can use a number of strategies to define find levels that have historically moved correctly 70-85% of the time over the past decade and many of these strategies are published in the TradingMarkets Swing Trading College (for those of you who are interested we’ll be launching our fifth Swing Trading College program early next month).

1. Country ETFs: Country ETFs are the most efficient and most reliable instruments to trade using overbought and oversold indicators. With country funds, you can create very simple strategies that have historically predicted short term direction greater than 80% of the time, and in the US indices up to 90% of the time. The key is to use the proper strategies and then use the appropriate position sizing. The reason is that no matter how large a historical edge has been, there will be trades that don’t make money and using correct risk management, you can manage those trades.

As I was taught many years ago from a very wise trader: "Worry about the losing trades. The winners will take care of themselves".

In summary, when you’re creating short-term trading strategies, understand that there is a difference in how stocks and ETFs trade. Stocks require the most oversold conditions above the 200 day before buying and the most overbought conditions under the 200 day before shorting. From there the order is Commodity and Currency ETFs, Sectors ETFs, and then number one are the Country ETFs

We’ll talk about this more in the future. We’ll also be talking more about risk management as we move ahead.