Practice of mean reversion strategy | chart of art

Mean reversion strategies typically buy stocks when they are oversold, which means catching a falling knife. These declines are often sharp, but some sort of bounce is likely after the oversold extremes are reached. Although there are no guarantees, a chartist can mitigate risk by ensuring that a stock is still in a long-term upward trend. Today’s chart shows one such setup. This stock is currently the setup for TrendInvestorPro’s mean reversion trading strategy for system traders.

The chart below shows Cadence Design System (CDNS) hitting new highs in a big move in November and trading above its 200-day SMA (long-term uptrend). CDNS has recently fallen 8% over the past two weeks, falling below its mid-December lows. Despite the sharp decline breaking the mid-December lows, the stock has broken resistance and is trading in a support reversal zone, indicated by the 50-62% retracement (shaded in blue). I explained the importance of the support-reversal zone in my Saturday commentary covering Apple (AAPL).

You don’t need an indicator to understand that the stock is oversold near-term after falling 8% in two weeks. Nonetheless, we can quantify oversold conditions using the RSI(10) which has moved below 30 (shaded in red). As long as RSI remains below 30, CDNS is oversold and weak. This is important to note because stocks can become oversold and remain oversold. An RSI above 30 is a sign of improving momentum and could lead to a rebound. This happened in mid-August.

TrendInvestorPro’s System Trader product implements a mean reversion strategy that trades stocks of the Russell 1000. This strategy identifies short-term oversold stocks, buys on weakness, and sells on the first bounce. This is a short-term hit-and-run strategy intended to complement our momentum rotation strategy. Click here to view performance indicators and learn more.

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