Welcome to the world of smart trading! Today, we're exploring a fun and effective trading strategy called mean reversion. Don't worry if it sounds complex; we'll keep it simple and engaging.
What is Mean Reversion?
Imagine a dog on a leash. The dog might wander off, but it always comes back to you. In trading, mean reversion is the idea that prices tend to move back to their average value over time.
What is Cointegration?
Now, imagine two dogs on leashes. Even if they wander independently, they stay close because they're tied to you. In finance, cointegration means two or more stocks move together in a predictable way despite short-term deviations.
How Does the Strategy Work?
Here’s the basic idea:
Find Pairs: Identify two stocks that move together over time.
Watch for Deviations: When one stock moves away from the other, we expect it to come back.
Trade on Reversion: When the prices deviate, we enter a trade expecting them to return to their normal relationship.
Example: Trading with MARICO and ITC
Here’s how our product will help you implement this strategy:
Input Stocks: You start by entering the scrips of two stocks into our system.
Check Cointegration: Our code checks if these stocks are cointegrated—meaning, they have a stable long-term relationship.
Backtesting: If they are cointegrated, the system provides backtesting results for the past four years. This means it shows how the strategy would have performed historically.
Current Position: Based on the latest data, our system will tell you if there's a potential trading opportunity right now. It will suggest whether you should open a position by shorting one stock and going long on the other, using the mean reversion strategy. Let’s assume the code suggests MARICO to be short and ITC to be long. Implying that we expect outperformance from ITC.
How to trade?
Futures
Short MARICO and Long ITC
Cash Segment
Long ITC
Why Does This Work?
This strategy works because cointegrated pairs maintain a stable relationship over time. By trading based on temporary deviations, we profit when prices revert to their mean.
Conclusion
The mean-reverting strategy based on cointegration is a powerful tool in trading. Our product makes it easy for you to use this strategy: input your stock pairs, check for cointegration, review backtested results, and get recommendations on current trades. Always practice good risk management and stay informed about the assets you’re trading.
Happy trading!
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