Last Updated on August 25, 2022 by Oddmund Groette
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?
The Rubber Band trading strategy is a simple but powerful contrarian/mean-reversion strategy for trading stocks, which is easy to understand and easy to trade. It aims to identify points where the market is overbought or oversold and likely to snap back towards 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!
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. This trading strategy aims to identify points where the market is overbought or oversold and likely to snap back towards the mean. Traders use Keltner Channels or Bollinger Bands for this strategy, others 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. 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.
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. The profit target should be at 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 at 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 an 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.
Rubber band trading strategy (backtest and example)
A backtest of a rubber band trading strategy is coming soon.