The Mean Reversion Strategy can be a very useful tool to identify which stocks to buy and when by giving entry and exit points that rely on historical data. Mean reversion is used by equity traders, day traders, hedge fund managers and portfolio managers. We’ll learn what it is, how it’s calculated, where to find some helpful tools and some of the drawbacks to utilizing this strategy.
What is the Mean Reversion strategy?
It is a method based in the statistical moving average of an underlying equity or asset such as currency or commodities. The mean, or the average, is center of where an asset trades over a period of time. The theory is that when an asset such as a stock is selling above or below its historical mean, it will return to that average selling price.
How is it calculated:
The simplest way is to go to the finance portion of MSN, Google, Yahoo or MarketWatch clicking their chart and selecting the technical analysis chart. Once the chart opens it allows you to choose the length of the moving average you would like to see with the price. Yahoo Finance for example allows you to choose, 5, 10, 50, 100 and 200 day moving averages and you can choose any or all of them together.
Figure 1 P&G Price Chart with 50 moving average
The other way to calculate the average is manually by downloading data into Excel or R from any of the financial search sites mentioned above. Using Yahoo Finance you would search for the stock you want to analyze by entering the company name or stock symbol. You would then select historical prices from the options on the left menu, the time period you’d like to see. At the bottom of the table is an option to download to a spreadsheet. You will need the Data Analysis Add –in and use the moving average function to utilize the data in this way.
Figure 2 Excel 25 day moving average of P&G stock
Using Excel in this way requires some knowledge of the program, installation of the addin and some effort to make a chart that’s equally useful to the version readily available on any number of websites. The advantage to using Excel is that alerts can set up to buy or to sell if your stock crosses a 50 or 100 day moving average. The downside is that you need to refresh the data every day the market is open to have the latest information to make decisions.
