Putting a Mean-Reversion Strategy Into Practice

Mean-reversion strategies typically buy stocks when they are oversold, which means catching the falling knife. These declines are often rather sharp, but the odds favor some sort of bounce after reaching an oversold extreme. While there are no guarantees, chartists can mitigate risk by insuring that the stock is still in a long-term uptrend. Today's chart will show one such setup. Note that this stock is currently a setup for the mean-reversion trading strategy for System Trader at TrendInvestorPro.

The chart below shows Cadence Design System (CDNS) surging to new highs with a big move in November and trading above its rising 200-day SMA (long-term uptrend). CDNS recently fell below the mid December low with an 8% decline the last two weeks. Despite breaking the mid December low with a sharp decline, the stock is trading in a support-reversal zone marked by broken resistance and the 50-62 percent retracements (blue shading). I explained the significance of support-reversal zones in Saturday's commentary featuring Apple (AAPL).

We do not need an indicator to understand that a stock is short-term oversold after an 8% decline in two weeks. Nevertheless, we can quantify oversold conditions using RSI(10) which moved below 30 (red shading). CDNS is both oversold and weak as long as RSI remains below 30. This is important to note because stocks can become oversold and remain oversold. An RSI move above 30 would signal improving momentum and could lead to a bounce. This occurred in mid August.

The System Trader offering at TrendInvestorPro runs a mean-reversion strategy that trades stocks in the Russell 1000. This strategy identifies short-term oversold stocks, buys into weakness and sells on the first bounce. It is a short-term hit-and-run strategy that seeks to complement our momentum-rotation strategies. Click here to see performance metrics and learn more.

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