All stocks have a price that is their mean, or the standard average. As Larry Connors, author of “How Markets Really Work,” observed, “Markets tend to revert to their mean on a short term basis. Once you figure that out, the game gets a bit easier.” Basically, stocks will return to the prices they were trading at in the short term. That is “reversion to the mean trading.” In other words, the price reached that price point for a reason and will return to it as it will still be the same company after the news that morning, unless it is a merger or acquisiton situation.
The factors leading to a big gain or big loss for a stock are endless. This is particularly true for a small cap, which many times are thinly traded. When a stock makes a big move, “hot money” immediately jumps in to chase it via program trading. Existing buy and sell orders are triggered, reinforcing the direction of the price movement (i.e., the “cascade effect.”)
Over a decade long period, Connors studied reversion to the mean trading for buying stocks that were at a 10 day high for the moving average and exiting when it closed below its five day moving average; and buying at a 10 day low below the 200 day moving average and selling when it closed above the five day moving average. The results, according to Connors: “Two things stand out. First, the average returns for the stocks that made 10-day lows is nearly double that of stocks that made 10-day highs. Even more eye-opening is the percentage of winning trades. Buying 10-day lows was correct nearly 65% of the time, while buying 10-day highs was correct only 38% of the time. ” From this, it appears as if the market overreacts in sell offs from negative news.”
Connors also noted that, “Markets are more efficient long term. There is little statistical evidence to support otherwise. But markets can be very inefficent short term. There’s ample statistical evidence to prove this, and that’s where the best opportunities are today.” Other articles on www.smallcapnetwork.com have focused on how traders can profit from fluctuations in the prices of the top losers and the top gainers each day.
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