081 - Trading the Mean Reversion Curve

One of the challenges of Mean Reversion trading is deciding when to get into a trade.

How far from the mean should we actually wait before we consider getting into a trade?

In a trending environment where the dips are shallow, getting in closer to the mean can bring lots of trading opportunities which can perhaps translate into more profits, however when market conditions change that approach can be a recipe for some big losses or drawdowns by getting in too early.

Mean Reversion traders can often experience a great run with lots of small wins, only to see them get wiped out pretty quickly, often in just a few big losses.

This has definitely happened to me in the past, especially in my stock trading, and I’m sure lots of other traders are listening and nodding their heads too.

In fact, I received an email about this exact challenge from a listener called Simon a few weeks back:

“I have a stock trading mean reversion model, that has all the right ingredients: great risk adjusted performance; incredible consistency; very large sample sizes for testing; simplicity; etc.

The one issue that I’m trying to improve is the nasty DD’s which occur naturally when trading correlated contracts (stocks) all moving south together, and continuing that way without reverting.

As you’d know, all available positions get sucked into these down moves, compounding the issue. Simple stops don’t seem to be the answer based on their overall impact on the system.

Couple of things I’m trying (sometimes in combination) and with some success:

– throttling number of positions that can be triggered per day, effectively spreading the risk over the down move.

– critical model-stop-and-wait functionality when DD increases.

– market regime based methods of throttling or stopping new entries.”

All 3 of these options are quite popular techniques that could help to reduce drawdown but there is another idea which PJ Sutherland shared with us back in episode 62 of the podcast, which I thought was quite interesting…

…and that was this idea of trading the mean reversion curve.

Let’s take a quick listen to PJ explaining this concept, because it has a number of potential benefits and we’ll see how it could possibly help in this type of situation.

Happy Trading,
Andrew.