The stock market tends to revert to its average price over time. This means that if stock prices move too far above or below their average, they are more likely to move back towards the average in the future. This is because many forces are at work in the market, including buyers and sellers, and these forces tend to balance out over time.
Let’s backtest the following hypothesis: The market opens the week lower, here is how that has played out historically.
When the stock market opens lower on a Monday, we might be tempted to believe it is more likely to close higher on Friday because of mean reversion and long-term tailwind. This is because mean reversion might happen over a week, as investors take profits from stocks that have moved too high and buy stocks that have moved too low.
Obviously, it is essential to note that mean reversion is not a guarantee. The stock market is also influenced by long-term factors, such as economic growth and corporate earnings.
Mean reversion trading strategies can be used to profit from the tendency of stock prices to revert to their mean. These strategies typically involve buying stocks that have fallen below their mean and selling stocks that have risen above their mean.
It is vital to backtest mean reversion trading strategies before using them in live trading. This means testing the strategies on historical data to see how they would have performed.
The Market Opens The Week Lower, Here Is How That Has Played Out (Historically)
Let’s backtest, and we make the following trading rules:
- Today is Monday,
- Today’s open is lower than yesterday’s close (normally a Friday, a Thursday if Friday was a non-trading day),
- If the first two bullet points are true, then buy the open.
- Sell at the close on Friday (the end of the week) or after 5 trading days.
The average gain is 0.23%, which is 15% better than any random week.
Worth noting is that only 31% of Mondays open down. You are invested only 31% of the time, thus, the risk-adjusted return is 12.6%, substantially higher than buy and hold.
We changed the trading rules and added the most used trend filter which is the 200-day moving average trend filter (Friday’s close must be above the filter).
We get the following equity curve:
The average gain is 0.22%, but we avoid the worst drawdowns: max is just 15%.