What is Mean Reversion and can it be used as a trading strategy to buy Stocks or Darwins?
Firstly, Mean Reversion is a theory used in finance or trading that suggests that asset prices and historical returns eventually will revert to the long-run mean or average level of the entire dataset.
This implies that it would be a good idea to buy when the share price falls below the average and sell it when it is above the average.
Mean reversion does hold water to an extent, but on its own, it can not be used to predict the future movement of a share/asset’s price. If the Mean is, (or changes), into a negative trend, the price would just revert to a lesser negative value. If mean reversion could be used effectively on its own to predict future price movements, it would be used by everyone. Longer-term mean reversion can be even more dangerous to use. I have done extensive case studies on mean reversion, and it is NOT a good indicator of future performance, especially not Darwins (and I will explain later). Share prices can stay above their mean avg. for years on end. Take Microsoft for instance. On the weekly chart, it has not gone below its mean since 2013. At the end of 2013 mean reversion would show that it would be a bad idea to invest in Microsoft (maybe even short it), in fact, that would have been a very bad assessment to make, as it has gained momentum continuously since then. All the best performing shares have this characteristic in common and Mean Reversion is a bad strategy to use in all these cases.
The other issue is that Stock prices and the prices of Darwins are definitely not in the same category and they are fueled and influenced by different factors.
Stock prices are influenced by the behavior and opinion of people regarding the value of a certain asset. The price of a Darwin has nothing to do with what anyone thinks, it is purely influenced by the trading strategy of the Trader/s. Mean reversion has no Influence what so ever on the possible future returns of a Darwin. That is a fact! …and especially not on Darwins. Mean reversion, and almost all Investable attributes have no real influence or indication of the future price of a Darwin. It is merely an Attribute or characteristic of the movement of the price over a period of results. Attributes or Indicators are just that! they give an idea of how the price moved and gives indications of what type of strategies are possibly used or how it possibly trades.
Isn't the best time to invest in stock or index or trading strategy, right after or during a drawdown, since the curve tends to go up and to mean revert?
Unfortunately, this is not the case and maybe this is a misconception among Traders and Investors, and why a lot of people are still holding on to the idea that IA (Investable Attributes) and other attributes like mean reversion has an influence on the future price of an asset. It really does not!
Darwinex has realized this, and hence the reason they are moving away from IA’s and the old D-Score, because of this.
This was my concern in the first post I posted on Darwinex, and I am pleased that they are making changes in the right direction.
To invest during or after a draw-down, it has to be split into either draw-down into Stocks/Assets/Indexes or draw-down in Darwins, as they are influenced by different factors. But they could have similarities in their price movements.
If we take the draw-down in Darwins, and here I would have to hypothesize as to the reasons for a draw-down, and 3 types of draw-downs come to mind.
The normal statistical probability of a stretch of losing trades, in which case a buy into the Darwins during this draw-dawn would result in a good positive result for the Investor. These should be short and sometimes medium-term occurrences.
The fact that a trading strategy has worked for some time, but is now (or over time) being “outdone” by a better strategy. And here I would like to expand.
Let’s say a certain Quant / Forex Trading company or Individual writes and sells a new strategy to 300 traders and they start making good money, but over time, even more people get to know about this strategy and almost everyone has it and trades with it.
The same Quant, or someone else, then realizes that they can exactly predict when the old program triggers and writes a new strategy that triggers right before the old strategy. This will be detrimental to the old strategy and would cause continuos draw-downs and losses over time.
A secret strategy is only a secret for a limited amount of time. People get to know about trading ideas and eventually your trading idea does not work anymore, and you buy (or write) a new trading strategy because it somehow is not working anymore.
If you buy or write your own strategy, they do not stay a secret forever. People figure stuff out and improve or trick previous strategies and benefit from it. Strategies become outdated or redundant by smarter or more greedy people, and this will leave the Investor wondering for years what has happened. “But it always had such good results for years? … and then 2 years of ‘bad luck’ came …I guess…and then the Darwin unlisted”
Most traders develop their strategies on the historical statistical probability of their entry and exit trade triggers. Unfortunately, these statistical probabilities do change as certain strategies get "over-used" by more traders and new (or revised) strategies show better returns.
The balance between different trading strategies will shift over a long period of time and different strats will again become profitable and vice versa.
The 3rd scenario could be one of the following
3. This could be a Martingale strategy or something to that effect and the draw-down is a complete crash and burn scenario.
So, in the case of a draw-dawn with a Darwin; which of these 3 draw-dawns are playing out? 1, 2 or 3? You won’t know unless you stick it out, and with each, you are taking a risk.
As an Investor, you could stick with a losing trading strategy for years because it had good results 3-5 years ago, but over the last 2 years, while you were invested, and while it also had a very good D-Score, you were tricked into believing it was a great Darwin.
Long term results are extremely valuable but the most recent results should give you the best indication of an improving or worsening strategy. The latest results (3,6 and 12 months) should carry more weight in making a decision and will be the most reliable to follow.
In the case of draw-downs with regards to Stocks. Here, the share prices are influenced by people’s perception of the valuation of an asset. And there are numerous reasons for the price, or the stock market as a whole to move.
The main “perception”, which is the driving force to an up- or downtrend, is semi-controlled by influences most people know very little about. Though this is a topic on its own.
The boundaries of the price movements, can more or less be determined, as well as the direction of share prices can be determined, as I have explained in this article about my program 1. It is also somewhat complex and I have only discovered the bull/bear infliction point in the latter part of my 35-year search for it.
Most, if not all Investment or trading decisions, are, and should be based on the statistical probability of an assets’ price to move in a certain direction and the size of the movement, either way, giving you the right risk to reward ratio to enter a trade.
Although these probabilities do change without a Trader, Investor, or Darwin provider knowing about it.
The probability of predicting the price of a Darwin through mean reversion or improving it by using draw-downs is just not feasible on Darwins.
The short term movements of Darwins do become more predictable with a lot more data, hence the reason why Darwinex needs to use as much data as they can, over as long a period as possible. But most Data and Time, are not functions of performance or returns.
Only past returns can be a function of future returns. That is the purest form to use it.