The edge of Mean Reversion Trades

Mean Reversion Trades

To be a profitable trader, you need to trade with an edge. What is a trading edge? In short, it is the opportunities or patterns that exist in the market that has a high probability of putting your trade in an advantageous position.

For an example, option sellers in generally have an edge as time decay is working in their favor. This edge in selling options allows us to collect the premium with each passing day.

Mean reversion is an edge we can exploit in trading. The idea behind mean reversion is simple. When the stock movement deviates too far from its mean, it will eventually move back closer to it’s mean.

For example, a particular stock has been displaying bullish trend for several weeks. However, in the last few days, there has been selling activities that weakened the stocks. If there is nothing unusual with these selling activities, then the selling can be considered to be a temporary deviation from the mean (bullish). We can expect the stock to resume the bullish uptrend. In this particular example, we can create put credit spread structures and take a directional bet on this stock.

Bearish Mean Reversion Setup – Example

PRU has been trading below the 200 SMA (red) and the 50 SMA(green) has consistently been below the 200 SMA. From a long-term perspective, PRU is bearish.

However, PRU did experience short-term overbought activities. In such instances, the RSI (3 periods) has crossed above the 80 level.

In this diagram, you will find that when RSI(3) crosses above the 80 level within the context of a longer-term bearish trend, PRU often reverts back to the mean and continue to move downwards.

There is no magic number behind the RSI settings. Different stocks show different reliability with the various periods and it is advisable for you to play around with the settings to see what suits the particular stock you are analyzing. You will find that for short-term overbought/oversold signals generally work well with the 2, 3 or 4 periods for most stocks. I have chosen the RSI(3) for the illustrations in this article as it is reliable for the underlying stock under case study.

Bullish Mean Reversion Setup – Example

NVDA has been trading above the 200 SMA(red) and the 50 SMA(green) has consistently been above the 200 SMA. From a long-term perspective, NVDA is bullish.

However, NVDA did experience short-term oversold activities. In such instances, the RSI (3 periods) has crossed below the 15 level.

In this diagram, you will find that when RSI(3) crosses below the 15 level (green circle) within the context of a longer-term bullish trend, in all of the 4 occurrences, NVDA reverts back to the mean and continue to move upwards.

Bullish Mean Reversion Setup – Example (With Entry and Exit Criteria)

  1. Current closing price above 200 SMA.
  2. 50 SMA sloping upwards.
  3. RSI(3) currently oversold. (e.g below 15 or 20)
  4. Enter a put credit spread (PCS) and ensure that the credit received is at least 20% of the width of the PCS. (profit ratio above 25%)
  5. Ensure that the short strike is at least 3% below the money.
  6. Establish a stop loss level using the short strike. If the short strike is breached, our original assumption that the stock is bullish is wrong and we will close the trade.
  7. Close the trade when profit reaches 70% of credit received.

Bearish Mean Reversion Setup – Example (With Entry and Exit Criteria)

  1. Current closing price below 200 SMA.
  2. 50 SMA sloping downwards.
  3. RSI(3) currently oversold. (e.g above 80 or 85)
  4. Enter a call credit spread (CCS) and ensure that the credit received is at least 20% of the width of the CCS. (profit ratio above 25%)
  5. Ensure that the short strike is 3% above the money.
  6. Establish a stop loss level using the short strike. If the short strike is breached, our original assumption that the stock is bearish is wrong and we will close the trade.
  7. Close the trade when profit reaches 70% of credit received.

Bullish Mean Reversion Setup – Example (With Entry and Exit Criteria)

AMAT has been trading below the 200 SMA and the 50 SMA has consistently been below the 200 SMA. From a long-term perspective, AMAT is bearish.

However, the RSI (3 periods) has crossed above the 80 level suggesting an overbought condition in the short term.

We can now look to enter a bearish trade using Call Credit Spread.

Finding Trades with Option Samurai

We will use the Option Samurai platform to scan for suitable call credit spread using the entry criteria outlined below.

  1. Enter a call credit spread (CCS).
  2. Add the ‘include symbol’ filters and enter ‘AMAT’ (you can enter several symbols or even copy-paste from excel).
  3. Limit the days to expiration to 30 or below.
  4. Ensure that the credit received is at least 20% of the width of the CCS. (profit ratio above 25%)
  5. Ensure that the short strike is at least 3% above the money.
  6. You may loosen the filter criteria to include only those shown in the diagram below.

SCAN RESULTS FOR AMAT

LOOSENED FILTER CRITERIA

Trade Entry:

SELL -1 VERTICAL AMAT 100 (Weekly) 7 SEP 18 53/54 CALL @.21 LMT

(Sell a call credit spread (-53 / +54) that expires on 7 Sep 2018 with a profit ratio of 25.68% and ATR vs Strike of 2.39)

Risk Profile

Go to Option Samurai

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