Rarely do I see any discussion in the trading community about the impact of reversion on the profitability of trades. Many new traders are completely unaware of this concept and its impact on their trading.
Value, Price, and Reversion
I spend a great deal of time educating my student traders about the major market participants: commercials, large speculators, small speculators and market makers. I want students to understand the different behaviors of different participants. Learning about these different behaviors often opens the eyes of my students helping them realize the other participants trade very differently than they do. When we look at the professional trading community, particularly commercials and market makers, we see that they establish models (fundamental or quantitative) that help establish a fair value for the products they trade. For our discussion here, we’ll use the mean price as our estimate of fair value.
Professional traders focus intently on entering and exiting positions with an “edge” to fair value. These traders are disciplined and focused on buying under fair value and selling over fair value. This edge to fair value has a major impact on their profitability. The same idea allows casinos to make money, especially in sports betting (casinos collect “vig”). The casino maintains an edge on every game and every bet. Market makers/commercials also try to gain an edge on every transaction. This “edge” helps them reduce the impact of losses and increase the size of profits in trading.
New traders come to the market with a myopic lens – “I’ll buy this stock and hope it goes up.” They limit their risk with an initial stop and with tight ongoing stops. They tend to give little thought to transaction costs, to who is on the other side of their trade, and to the price they paid relative to the mean. Average retail traders often take trades at a negative edge to fair value. That is, they give away money relative to their trade’s potential.
I teach my students to become “value” traders. They are to buy and sell as close to fair value as practical. We use the phrase –
Value is rational. Price is emotional.
When someone buys a long position too far over the mean or sells it too far under the mean, we can know that they are engaging in emotional trading because they have lost their sense of trading relative value to fair value.
With this idea in mind, let’s examine the concept of Reversion.
Positive Reversion vs. Negative Reversion
One reason for learning the different participants and different styles is so that we can borrow edges from them to create our own optimum strategy.
- Positive Reversion – Trade made with a positive edge to fair value (Long: buy under Mean, sell over Mean).
- Negative Reversion – Trade made with negative edge to fair value (Long: buy over Mean, sell under Mean).
In my experience, I have seen many new traders choose breakout strategies with trailing stops as one of their initial systems to trade. This type of strategy, however, has a negative reversion entry and a negative reversion exit. The logical and proven rationale for positions is to let your winners run, however, traders using this kind of system ruin their results by taking profits too soon. There is another aspect of this type of system, however, that is worth examining more closely.
NOTE: THE FOLLOWING EXAMPLES ARE HYPOTHETICAL AND NOT MEANT TO BE RECOMMENDATION FOR ANY TRADE OR INVESTMENT. THIS MATERIAL IS FOR EDUCATIONAL PURPOSES ONLY.
A “Typical” Keltner Channel Breakout System:
Keltner Channels are indicators based on standard deviations. “K” Bands (for Keltner Channel) form at above and below a mean (usually a simple moving average) and represent different standard deviations around the mean. Typically, a chart will have a set of positive K-Bands and negative set of K-Bands (K1-K3 for 1-3 Average True Ranges or ATRs). Sometimes traders will even place a 4th ATR band on the chart and sometimes people run Keltner Bands at different levels than just ATR (such as Fibonacci levels).
(Note: I don’t use Keltner Channels, however, they are common and will help me illustrate an important concept.)
A standard Keltner Channel Breakout system might look for a close outside of the K2 line (2nd ATR). A move like this would be considered significant and identifies a potential large trend. We will define our mean as the Simple Moving Average around which the K-Bands are placed.
Such a system might look something like this –
Standard Long Keltner Channel Breakout System
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- Enter on close > K2. Typically, K2 is 2ATR away from the mean (Think about this entry at 2ATR over the Mean. We are giving up -2ATR in negative reversion.)
- Initial Stop – < Mean – Initial stop set below the mean and it does not move until it is 1 ATR < Mean
- Trailing stop = 1ATR < Mean (We are selling position for 1 ATR less than the mean – a -1ATR in negative reversion.)
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Do these rules seem reasonable or even similar to some systems you might have seen? The rules as stated, however, give up -3 ATR in reversion: -2ATR on entry and -1 ATR on exit. What does that mean? Price will need to move 3ATR just for the trade to breakeven. Herein lies the inherent problem with these kinds of systems – they enter and exit on negative reversion. That costs too much money to ever be effective!!! This system would have to be totally awesome to overcome 3ATR of negative edge on every trade!
Let’s see how a trade from this system looks on a chart.
Example #1 – Keltner Channel Breakout System – Applying Negative Reversion Rules
For this trade example, let’s find the Max Favorable Excursion (MFE) or the distance between entry and the most favorable price the trade reached in our favor. Then let’s measure the MFE in relation to the exit to see how efficiently the exit captures the move by a metric called the Excursion Ratio. We calculate this by the MFE by the ticks captured. In the example above, our trade is a 25-tick winner and the MFE was 65 ticks so our Excursion Ratio = 38.5% (25/65). We also look at our final R multiple which in this case is +.58R (.25 profit /.43 initial risk = .58).
Once you understand the effects of negative reversion, you probably would not want to trade the system as is. That it finds a trend, however, is useful. How could we change the rules to capture that trend but at the same time, reduce negative reversion and capture positive reversion? Let’s look at a different version of such a system.
A Different Way to Play
We could revise the rules to enter on a shallow pullback after the Breakout signal. I have found in my research that breakout trades typically need a stop that is twice as big as a pullback trade. Why? Because of the difference in Negative Excursion (Breakout) vs. Positive Excursion (Pullback). That means the same size move usually yields R twice as big for a pullback vs. a breakout.
In addition, we revise the exit to give us an exit condition (protocol) instead of an exit signal. What does this mean? When certain price behavior occurs, we begin to look to exit by selling high. I find traditional trailing stops to be one of the largest roadblocks to success because these exits strangle the trade. The trader is so “scared” of giving his profits back that he ruins his trades (this topic is an entire article in itself 😉). Instead of getting out of the position on the exit signal, we use the signal as a condition to begin to sell high. When we have the trend on our side, we often have much more time to exit the trade than new traders initially think. We use time on our side to sell high, often near the highs on a retest. By exercising patience through the exit condition, we exit for positive reversion.
With those different entry and exit rules, here’s a revised version of the Keltner Channel System using Positive Reversion Principles
- Entry – After a BO > K2, we wait to buy the first pullback to K1.(Now are only giving up 1 ATR of negative reversion and it allows us to enter on shallow pullbacks).
- Initial Stop is the same as before, <Mean. Because we bought on the pullback to K1, our mean has actually risen another 10 ticks during the time we waited.
- Trailing Stop = behind -K1 Band.
- Exit – After first time price closes below the Mean, exit at +K1 (above the mean and if we get filled on this trade, we will be exiting for a > +1 ATR edge).
This set of rules changes the game entirely. We will either be exiting for a +1ATR Positive Reversion or slightly larger than -1ATR Negative Reversion. This makes our net reversion now equal 0 instead of -3.
Example #2 – Modified Keltner Channel Breakout System – Applying Positive Reversion Rules
Now when we examine the trade metrics, we see the system has an Excursion Ratio of 93.2% as we capture 69 ticks of the 74-tick move. In addition, because we entered on a pullback to +K1 instead of the Breakout > +K2, we were able to reduce our initial risk to 24 ticks from 43 ticks. By entering on a pullback and selling on positive reversion retest, we were able to improve our R-multiple from +.58R to +2.875R.
These changes are a major improvement to this system— but—there are always trade-offs to consider. Using the modified rules, the system would never get in if price didn’t get the pullback. Also, our exit could be worse for our trailing stop if we don’t get the positive reversion move where we look for an exit. On balance, however, crafting entry and exit rules to capture positive reversion adds significant value.
Lessons Learned
Different ways of executing the same trade setup can massively improve trading performance.
If you want to generate profits like a professional trader, do more of what they do – focus on trading as close to fair value as practical by limiting negative reversion. The result will be major improvements in your trading results.
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If you are interested in applying the edges of fair value and reversion to your trading, Mark and I will discuss how the Reeds trading strategies integrate these concepts in proven systems at our upcoming Reeds 201 live stream workshop on April 17-18.
Check out Reeds 201 at www.vantharp.com/reeds-two-advanced