Mean Reversion using Linear Regression Curves

We presented the concept of mean reversion in an earlier post, in this article we will present a tweaked version of mean reversion that utilizes Linear Regression Curves instead of moving averages.

Moving average is a lagging indicator so essentially the Linear Regression Curves can potentially provide a better fit of the available data. It is helpful to compare the results of both methods nonetheless – same applies to any tweaked versions tested, it would make sense to first compare to the base version.

Linear Regression Curve is essentially a bundle of numerous lines, but the extreme ends of the lines are hidden (upper and lower bounds), while the mid-point is only shown and is connected respectively to other mid-points across the time series.

Back-test implementation of mean reversion on S&P500 stocks using Linear Regression Curves:

  • Estimate the Linear Regression Curve per look-back window
  • In each day compare the closing price with the average value estimated;
  • If the closing price is greater than the average + n * deviation go short  and close when you cross the mean or at a pre-determined time
  • If the closing price is less than the average – n * deviation go long and  close when you cross the mean or at a pre-determined time

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