When I analyze technicals and charts of stocks one of the main drivers is mean reversion. Simply put a moving average (mean) acts as a magnet towards price either up or down. Go to far to the upside and expect price to come down, likewise a steep drop. That was the case yesterday as the price moved too far away from the shorter term moving averages (10 and 20 MA were the ones I focused one). Now, there is no guarantee of a snapback but the odds favored it.
We don’t often see price sitting in the ‘outlier’ position for very long. What is an outlier? Take a look at how Bollinger Bands are applied. I use the 2 standard deviation with a 20 MA. Simply put the bands will contain 95% of the action for the last 20 sessions, anything above or below the bands is an outlier (or called the ‘fat tail’). Moving averages are smoothing mechanisms that enable the examiner to get an idea of volatility and range in a stock.
So, back to mean reversion. We saw the SPX veer off to a near 4 SD away from the mean or 20 MA. Grossly oversold by these (and other) metrics. What are the odds of that occurring? Very very small chance. To be three SD away from the mean implies a 1% probability, so we are talking far less than 1%. If you wanted to bet on a 99.9 Buying at the close on Friday clearly gave you the best odds to benefit from this extreme oversold condition.
Since I’m sure many of you just LOVED your statistics class back in college (ugh, good grief!), I’m going to lay some stats on you here. For a three SD event to occur there is a 1 in 370 chance or once yearly probability. That is really extreme. A four SD event occurs every 43 years or twice in a lifetime (now, given our timeframes are shorter with stocks we will clearly reduce but the probabilities are the same – these are data points/instances). These occurrences are extremely hard to find as you can imagine.
I hope the point is clear that being far away (too far?) presents a good short term opportunity but you have to be willing to buy against the grain. There was nothing pretty about the close last Friday with a highly elevated put/call, extreme bearish sentiment and a rising VIX, not to mention expiration. Hindsight 20/20? Sure, and frankly this is not my game as far as playing for falling knives. Could this trade have been a bust? Absolutely, and unless you were selling some yesterday or today it could really come back to bite you. It happened often in Summer 2011 and then in Fall 2008.
Simply put the mean reversion trade is not a change in trend rather a counter attack on the current trend to relieve excesses. Timing is critical but the odds are very good if you are patient. In this market of quick moves and emotional responses you rarely have to wait too long.