Last Updated on October 19, 2022
As Warren Buffett rightly said: “You need to be fearful when others are greedy, and greedy when others are fearful.” This perfectly applies to the Rubber Band trading strategy, but what is it?
It aims to identify points where the market is overbought or oversold and likely to snap back toward the mean. Some traders use Keltner Channels or Bollinger Bands for this strategy, but others use momentum oscillators.
Want to know more about this strategy? Keep reading! Additionally, at the end of the article, we provide you with a backtested Rubber Band trading strategy.https://www.quantifiedstrategies.com/membership-signup/
What is the Rubber Band trading strategy?
The Rubber Band trading strategy is a simple but powerful strategy that is easy to understand and easy to trade.
It is based on the contrarian principle and the mean-reversion strategy (why mean reversion strategies work). This trading strategy aims to identify points where the market is overbought or oversold and likely to snap back toward the mean. Traders might use Keltner Channels or Bollinger Bands for this strategy, while others might use momentum oscillators.
Experience has shown that the price of a security has a central tendency, just like any other time series. What this means is that the price tends to revert to the mean after moving significantly away from it in any direction.
Note that the tendency of the price to mean-revert is not dependent on whether it is ranging or trending, and it’s not affected by the trend direction. In an uptrend, the price tends to revert to its rising moving average whenever it is overextended to the upside or the downside (moving averages are useful to define the trend). The same happens when its moving average is declining in a downtrend or when it is flat in a ranging market.
To trade this strategy, you must have the contrarian mentality — as Warren Buffet said, you must look to buy when the market looks battered and depressed and look to sell when the euphoria is very high and everyone is very positive about the market. In other words, the opportunities to buy come when there is too much negative sentiment, and people are losing hope and pulling out of the market (how to use sentiment indicators).
An example of the Rubber Band strategy indicator(s)
A common indicator for trading this strategy is the Keltner Channel. The usual setting is 20 periods with a 10-period ATR (average true range). When the price trades above the upper band of the Keltner Channel, there is a high chance that it will reverse and decline, at least, to the mean, but in some cases, it will fall lower and even get to the lower band.
Likewise, when the price trades below the lower band of the Keltner Channel, there is a high chance that it will reverse and rise to the mean or even go higher and get to the upper band.
So, when trading with the Keltner Channel, the buy setup occurs when the price is trading below the lower band of the channel. By this, we mean that the price bar opens and closes below the lower channel. It may be better to wait for a reversal candlestick pattern, such as the hammer or an inside bar to confirm a potential bullish reversal. However, as always, this needs to be backtested.
The profit target should be in the middle band, which represents the mean, or just before the upper band.
Similarly, a sell setup occurs when the price is trading above the upper band. A bearish reversal candlestick, such as the shooting star or an inside bar may help confirm the potential bearish reversal. The profit target should be in the middle band or just before the lower band. See the chart below:
Which indicators can you use for Rubber Band strategies?
For the Rubber Band strategies, traders use indicators that can show the price’s mean values and when the price is stretched in the upward direction (overbought) or in the downward direction (oversold). Some of the indicators you can use for this strategy include:
- Keltner Channel: The Keltner Channel or KC is a technical indicator that consists of volatility-based bands (or channels) set above and below a moving average. The volatility measure can be the average true range or the standard deviation. The price trading above the upper band signals an overbought market, while below the lower band indicates an oversold market.
- Bollinger Bands: The Bollinger Bands is a volatility-based technical indicator developed by John Bollinger. It is used to measure a market’s volatility and identify overbought (when the price is above the upper band) and oversold (when the price is below the lower band) conditions.
- A moving average plus a technical trading oscillator: Here, a moving average shows the price’s mean values, while the oscillator is used to know when the market is overbought or oversold.
You might find more interesting ideas among our backtested trading indicators.
Rubber band trading strategy (backtest and example)
Let’s go on to backtest a rubber band trading strategy that is based on the mean-reversion principle.
As an example, we use a strategy we first published as early as April 2013 in XLP (please read about XLP trading strategies). We can make a pretty solid out-of-sample backtest because of the time that has passed since then!
We make the following trading rules and settings:
- Calculate a 10-day average of the (High minus Low – (H-L)). That is the “ATR”.
- Calculate the High of the last 10 days.
- Calculate a band 2.5 times below the 10-day High using the average from point number 1 (ATR).
- If XLP closes below the band in number 3, then go long at the close.
- Exit when the close is higher than yesterday’s high.
The equity curve of the strategy looks like this:
There are 328 trades, the average gain per trade is 0.45%, the CAGR (what is a good CAGR?) is 6.1%, the time spent in the market is only 20%, the profit factor (which strategies have high profit factor?) is 2, and the max drawdown is 16% (drawdowns result in lower CAGR and compounding).
Pretty solid results for such a simple strategy (with almost ten years of out of sample data).
You can get the Amibroker code for this strategy plus over 100 other strategies. The strategies are compiled from our best free trading strategies.
Rubber band trading strategy – ending remarks
The rubber band strategy is based on mean reversion and thus works mainly on stocks. Other assets, like gold and commodities, for example, are much more difficult to trade with these types of systems.