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Old 09-05-2010, 10:39 PM
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Default Trading with Mean Reversion

Throughout financial history, there has been three effective ways to make money. They are, not in particular order:

1. The carry trade. This is where one borrows and leverages in a market and buys in another. An arbitrage is a carry trade, for example. This carry trade works very well at the beginning of a theme - that is, until everyone and his neighbor has adopted it. The yen carry trade that blew up in 1998 was one great example of the end of a carry trade.

2. Momentum "investing." Everyone should be familar with this trade, as I am sure virtually all our readers have gone through the 1990s technology bubble.

3. Mean reversion trade. This is where one buys an undervalued stock or commodity and wait for it to return to its true value. Warren Buffett is known for adopting this strategy to perfection (although he has done other trades at various points in his career).

Even though the world's financial markets have gotten more efficient as time goes on, mean reversion trades have still invariably "popped up" every now and then. They come into being when three forces come together:

1. Group think and a herd mentality: The universal belief that an asset class has just got to go up or down forever - resulting in a huge overvaluation (relative to historical average) of the current asset class in favor. The most recent example has been the bottoming of the U.S. Dollar in January this year. Not surprisingly, the U.S. dollar bottomed at about the same time a front-page bearish article on the U.S. dollar appeared on Newsweek.

2. The ability for retail investors to participate in such a trade - and the widespread publicity this trade has "enjoyed" from the mass media.

Traders who utilize the Market Profile framework should be quite familiar with the mean reversion trade. When we test edges of the value range and cannot facilitate trade at higher or lower levels, a move back toward the point of control is a high probability trade.
http://www.youtube.com/watch?v=1IFXMS9xn_E

Last edited by anirudhsnewworl; 09-05-2010 at 10:50 PM.
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