A moving average is a running average of the closing price of a stock over x number of time periods. The two most widely used averages are the 50day and day moving averages. Moving averages are not just used by specially trained market technicians. Today I want to bring my discussion of moving averages to a close by talking about one more way to use moving averages.
This is, in fact, the most profitable technical trading strategy I use. The phenomenon I am referencing here has a fancy label. The idea behind mean reversion, in a nutshell, is this: Thus whenever that sentiment drives share price too far from its average, the efficiencies of market forces being what they are, share price is bound to revert back to its mean in short order.
Determining just when price has been stretched too far from its average, and just how far back to the mean it will travel when it does revert, is more art than science. But there is one tool that can help us greatly with this determination. Using past price performance over X number of time intervals, this tool measures standard deviation from a moving average and draws bands on the chart, both above the below the average, that show the upper and lower limits of that deviation.
It is expected that price will stay contained within these bands going forward. But when the Bollinger Bands are not working well, your trading based on them can go horribly wrong. Still, when we couple the Bands with stop-losses to minimize the damage, they are the best tool we have for determining regions of price extremes where a stock or index is likely to get over-extended and flip back to the mean. Let me show you some examples.
EBAY with the day moving average overlaid, along with the upper and lower Bollinger Bands set at 1. You can see how over the past 9 months, whenever price travelled outside either band, it was only a matter of time before it bounced back the other direction. I used a standard deviation of only 1.
Here is a chart of Amazon, Inc. I have here overlaid the 50day moving average with bands set at 2. You can see a greater number of signals compared to the chart above, and also that some signals would have been more profitable than others. As you work with Bollinger Bands, you will want to refine your trading system. You cannot simply buy every dip below the lower Band and sell short every rally above the upper Band. As you experiment, I suggest integrating some of the following suggestions into your trading system:.
Mean reversion theory is a well attested phenomenon that, when learned well and traded appropriately, can be a very profitable approach to the markets. If you are looking for more resources on this trading system, you might want to try the Mean-Reversion Trading Manual I offer on my website, DrStox. You can also look at my book, Market Neutral Trading , where I fully explain how I use this trading system. But certainly the original source is always a good place to start too: Join awesome people who get the latest free content from Dr.
Stoxx Options Letter in their inbox. Stoxx Options Letter About Dr. Thomas Carr — Author. As you experiment, I suggest integrating some of the following suggestions into your trading system: Stoxx Options Letter on Mar 03, — 4: Check out what my VIP members get. Recent free content from Dr. Break the ice and be the first! Error loading comments Click here to retry. No comments found matching this filter. Take me to the new comment box!
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