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Using the "Dr. Stoxx Trend Trading Toolkit" to Trade Mean Reversions

Contributed by Dr. Thomas K. Carr

The Mean Reversion setup has impeccable credentials. Versions of it are used by some of the best known and most successful technical traders and analysts. It has been tested and back tested every way imaginable, proving itself profitable in all market conditions on all security types and derivatives. When the Mean Reversion system is done properly, there is no more exciting, more profitable, and yet more (nearly) mechanical trading system out there.

The key thesis of the Mean Reversion system is stocks that trade a statistically significant distance in price away from their mean, measured in our case by a moving average, tend, once a point of equilibrium is reached, to revert to that mean in short order. What we are adding to this thesis is that when we limit stocks that have travelled far from their mean to only those showing strong growth potential (for longs) or the lack thereof (for shorts), we improve our odds significantly of a successful reversion. This reversion is what we trade.

INTRODUCING THE SYSTEM

The Mean Reversion concept came into its maturity with market technician and financial analyst, John Bollinger (b. 1950). Bollinger swapped out Keltner Channels' use of ATR (Average True Range) for standard deviation (2.0). With this revision, Bollinger created trading bands that both envelop most of the price action over time, but are also dynamic enough to show changes in both volatility and directionality.

The Mean Reversion system I teach uses Bollinger Bands as its primary technical tool. On the longs side of the system, we are looking for stocks that have traded outside of the lower Bollinger Band, and which are trading significantly under their "mean" (the 20sma). I also apply a fundamental filter which favors those stocks that show strong earnings growth, low debt to equity, and recent institutional and/or insider buying.

On the shorts side of the system, we are looking for stocks that have traded outside of the upper Bollinger Band, and which are trading significantly above their "mean". Our fundamental filter on this side of the system looks earnings deceleration, and institutional and/or insider selling.

The Mean Reversion system detailed below is one I recommend you always trade in market-neutral pairs. This means for every long position you take you will need to find a short to mate it with; and for every dollar you have in that long, you should put a dollar into the matching short. The long/short pairs are treated as a single position: they are entered at the same time and exited at the same time. When done well, this system can hand you double digit monthly returns, and triple digit annual returns, regularly and reliably. The spreadsheet shown below (Figure 1) is my trading log for an eight week test (2012) of the system using a real-money account of $10,000. The average gain per week, including the losing weeks, was +3.3%. This is about in line with subsequent tests of the system. The total ROI was over 28%, or roughly +170% annualized with the compounding of gains.

TRADING THE MEAN REVERSION SYSTEM

Before you begin trading the Mean Reversion (MR) system, please remember that no claim is being made that following the step by step procedure as stated below will lead to profitable trading. It has in my case, but it may not in yours; nor in mine going forward. With that disclaimer out of the way, let's get down to work. Here are the tools needed to trade this system:

• Use MetaStock's "Dr. Stoxx Trend Trading Toolkit" if you do not want to program in your own scan. You will find both the long and short version of this system preprogrammed into the "Long + Short Mean Reversion Scan" in the TTTK add-on. With a single click of the mouse, you can scan the markets in real time for current MR setups. 
• You will also need to bookmark the following website. We will be using this free service to perform a basic but very thorough fundamental analysis on whatever stocks pass our technical scan:
  • Navellier's "Portfolio Grader" (Google the name and you'll get the URL)

RUNNING THE LONGS VERSION

STEP 1: Open MetaStock and go to the Power Console. Click on the "Explorer". Select "STTK - Long + Short Mean Reversion Scan." From the "Select List(s) to Explore" table, highlight "U.S. Optionable Stocks" or any other list you wish to scan. Click "Next", then click "Start Exploration". Make a watch list of charts for all passing candidates.

You should get 6 to 10 passing candidates each day. Since this scan targets price extremes, you will normally have more long candidates than shorts in downtrending markets, more short candidates than longs in uptrending markets, and fewer candidates of both sorts in less volatile markets. When the general market is itself outside the upper or lower Bollinger Band, you may get dozens of passing candidates come through the scan. In this case, it is best to modify the moving average filter. When you open the "Edit" function for the "STTK - Long + Short Mean Reversion Scan", you will see the following code line:

• C< Mov(C,20,S) * 0.9

Simply change the "0.9" multiplier to 0.87 and run the scan again. Keep lowering the multiplier if needed until you attain a list of only 10 to 15 passing candidates.

STEP 2: Take your list of passing candidates and input them, one by one, into Navellier's "Portfolio Grader". When you do so, you will see 11 categories each with a grade ranging from "A" (best) to "F" (worst). There are three general categories: "Fundamental", "Quantitative" and "Total". We are only interested in the "Fundamental" grade.

Your best candidates for the long side of the MR system will show an "A" or "B" for its "Fundamental" grade. If you have a number of "A" and "B" candidates, give favor to those with the highest grades in the first four "growth" categories: "Sales Growth", "Operating Margin Growth", "Earnings Growth", and "Earnings Momentum". Two or more "A's" is a good indicator that we have a strong candidate for this system.

STEP 3: Do further discretionary analysis on any passing candidates from Steps 1 and 2. At the least, this should involve checking the headlines for any possible "deal breaker" story about each company. Stocks usually hit extreme prices for good reason, but these setbacks often provide trading opportunities as they bounce back to the mean. What we want to avoid in this important step is getting into any company that is experiencing systemic problems. These can include things like accounting scandals (remember WorldCom?), an unexpected FDA rejection, mines and wells that run dry, and so on. We want to avoid these things.

This system works best when traded in market-neutral fashion with long-short pairs. Thus once you have completed Step 3, you will want to run Steps 1, 2 and 3 for the shorts side of the system (simply reverse the "Portfolio Grader" requirement to favor stocks showing "D" or "F") and trade accordingly.

STEP 4 (position management): There are a number of ways to manage the paired positions in the MR system. The one that generates a higher win percentage is as follows:

• Exit any MR system long/short pair using a "Market on Close" order after 3 full trading days have passed since entry, if and only if either the long or the short position is trading at or beyond the 20sma (above the 20sma for the long, below for the short), or
• 10 trading days have passed since entry, whichever comes first

CHART EXAMPLES

Hawaiian Airlines, Inc., (HA) began as a regional airline back in 1929 with two small planes serving residents of the islands. Today it serves 8 million passengers a year who fly all over the Pacific Rim. Though hard hit in 2013, HA has been known as a strong growth stock with its acquisition of new planes, hubs, and destinations. It is also a prime study in Mean Reversion: it has signaled ten MR longs since January, 2009, eight of which were profitable. In the chart below (Figure 2), you will two of those signals straddling either side of a downtrend. Note that the MR system returned +20% going long over a period when the stock itself traded down:

Biolase, Inc., (BIOL) is a medical equipment maker that among other things makes dental lasers, pain treatment applications, and 3D imaging machines. The shares of the company, long the target of the momentum day trading crowd, have a way of getting ahead of themselves. Its chart looks like a silhouette of the Grand Tetons. Once these peaks reach equilibrium, where supply and demand match up evenly, it is time to put on the short position. The MR system is designed to catch these reversals of momentum. In the chart below (Figure 3), you will see three such shorting opportunities totaling over +38% ROI.

About the Author:

Aka "Dr. Stoxx", Dr. Thomas Carr is the founder and CEO of Befriend the Trend Trading, and author of two bestsellers: Trend Trading for a Living and Micro Trend Trading. He has been actively trading the markets since 1996 following several years of studying technical analysis. He is also the Founder and CEO of Kingdom Capital, LLC, and a General Partner of The 8:18 Fund, LP. He is the developer of the strategy used by the 8:18 Fund and is sole manager of the Fund's portfolios.

Dr. Carr earned Masters and Doctorate degrees in Philosophy from Oxford University (UK). He is a tenured Professor and has over 16 years of investment, trading and trader training experience. In 2002, he founded Befriend the Trend Trading, LLC, an investment advisory service offering three daily market letters and various trading seminars. He is also the author of two bestselling books, Trend Trading for a Living (McGraw-Hill, 2007) which has been translated into Korean and Chinese, and Micro-Trend Trading for Daily Income (McGraw-Hill, 2010). Dr. Carr has been interviewed by the Wall Street Journal and the US News and World Report for his expertise in market psychology. He also had a series of articles published in Stocks and Commodities Magazine.