Here’s a look at Dow 10,000 you probably haven’t seen before:
Finance is a closed system. It’s not run by a perpetual motion machine. So the famous up arrow always stalls somewhere. What we want to know is just where is price in relation to time? The probability of price correcting back to an average value eventually becomes more and more certain.
The chart above is that last two years of the Dow using linear regression. Here’s a list of the current Dow 30 names. Out of those thirty companies some are stronger and some are weaker. So this isn’t a definitive science. It’s an art, but it is finally a spot to take notice. Let’s dig more into linear regression to see why it can be so useful.
68-95-99.7 Rule
In statistics, the 68-95-99.7 rule, or three-sigma rule, or empirical rule, states that for a normal distribution, nearly all values lie within 3 standard deviations of the mean.
About 68% of the values lie within 1 standard deviation of the mean (or between the mean minus 1 times the standard deviation, and the mean plus 1 times the standard deviation). In statistical notation, this is represented as: μ ± σ.
About 95% of the values lie within 2 standard deviations of the mean (or between the mean minus 2 times the standard deviation, and the mean plus 2 times the standard deviation). The statistical notation for this is: μ ± 2σ.
Nearly all (99.7%) of the values lie within 3 standard deviations of the mean (or between the mean minus 3 times the standard deviation and the mean plus 3 times the standard deviation). Statisticians use the following notation to represent this: μ ± 3σ. (Wikipedia)
| Range | Population in range | Expected frequency outside range | Approx. frequency for daily event |
|---|---|---|---|
| μ ± 1σ | 0.682689492137 | 1 in 3 | Twice a week |
| μ ± 2σ | 0.954499736104 | 1 in 22 | Every three weeks |
| μ ± 3σ | 0.997300203937 | 1 in 370 | Yearly |
Timing
So the trick is to find that slice of time where you have a 95% chance of being right. Year to date we are approaching a two standard deviation move in three months. Mean reversion traders look for price near high/low channel lines. Price matching on multiple time frames can provide some great low risk entries.
Here’s the Dow for the last two months. You can see it’s in a nice up trend, but the larger two year trend is going to put pressure on this short term trend. There’s obviously wiggle room here.
Catching a reversal near an extreme is key. Like after a 200 point Dow day. Two weeks ago there were 22 stocks aligned at 20/40/60 day lows. Three months of price coalesced into a single inflection point. From that list the 14 cleanest charts were picked. And these weren’t cherry picked later. These names all came from charts posted here on October 1st (see gallery). This method made 13% in a week. Going long the Friday after a -200 point drop (see story) was a low risk strategy using linear regression.
Went long Friday’s open on Oct. 2nd and sold at the close on the next Friday:
Referring back to the two month Dow chart we see there was still plenty of upside after the Oct. 2nd push off the lower channel. Price ran back to the median line and moved higher. However, holding two weeks into the next Friday’s close on Oct. 16th did nothing for the portfolio.
Trailing every name that made more than $500 profit with a $500 stop would have grossed $16,000 in one week. That left only RIMM and CAKE as open positions. The risk of holding for one extra week would not have made much of a difference. The ultimate intraday high of this portfolio was $20,000 which happened five minutes before the close on Thursday the 15th. Good luck timing that exit!
Note: these are examples of trading a mean reversion strategy. They are theoretical and not trading advice.
Sixty Names
Going through two year charts tonight shows a ton of potential shorts coming. A push or another 200 point day to put the market near the top of the two month channel would be an ideal setup. The more time frames that line up the better odds for a reversal. A scan of roughly 400 active stocks shows there are sixty near two year highs:
Gallery of 60 Stocks Near Two Year Highs
At or very close to two year channel highs:
BLK IOC CLNE BZH JADE SRZ PCLN GOOG BAC GE CAT CBI SLB
Just hit two year line and failed:
BIDU WDC WYNN
Pattern to Watch
The stock NTES has already completed a move we’re looking for. Price reached a two year high, failed, then returned to the median line in a clean trend with a clear exit.
NTES 2 year
Price tested the two year high twice then failed back towards the median line.
NTES 20 day
This one month chart is an example of how to stay in the trend. Price failed on every one sigma test with a nice clean exit on the lower channel.
NTES 3 month
Using 20/40/60 day LR lines shows an inflection point to short the stock. The spike above the channel was a great low risk entry. The spike below was a great exit.
Note: There is an art to the best time frame entry using this trading style. Also, shorter term channels adjust constantly. There’s wiggle room on the sixty names. What LR channels clearly show is the trend and where price lies within that trend.
Shorting the extreme high/low is often a low risk entry. The odds of price gaining more momentum to push above a two year channel are less than the odds of price reverting back to an average. Mean reversion is going to come into play soon with every major index. Because there are so many names setting up this points to shorting certain highs as a very good risk/reward.
As stated before there are no guarantees in the market. It can do anything at any time.
