Stockpickr: Mean Reversion Means Profits

At Stockpickr, we keep track of active trading systems for short-term trading that have produced superior backtested results in both bull and bear markets.

Every day, we look at a number of ideas and patterns in the market, ranging from the January effect (a general increase in stock prices during the first month of the year) to trend breakouts, moving-average systems, gaps, etc.

I've written a great deal about trading systems, both at TheStreet.com and in my first book, Trade Like a Hedge Fund. My main philosophy is that I like to keep things simple. The more complicated a system is, the more likely it's a fluke that has nothing to do with human behavior and just happened to produce good results for a while.

So that's why I like the 3x2 system. Here's an overview:

• Buy: When a stock goes down three days in a row, buy at the open the following day.
• Sell: If you own the stock and it goes up two days in a row, sell at the close of the second day in a row that it's up.

The idea is that stocks don't go down forever, nor do go they up forever. They do what's called mean-reverting: If stocks deviate too far from their average (mean) over a few weeks or months, they tend to snap back to it eventually.

So how has the 3x2 system performed? The results of a simulation from January 1997 through December 2006 on the Nasdaq 100 index (plus deletions), using 2% of equity per trade, were as follows: Out of 16,777 trades, 10,706, or 64%, were successful trades. And the average return per trade was +1.93%.

The systems has done well in both bull and bear markets. Take a look at the chart below:

To examine the system further, check out the 3x2 System page on Stockpickr, which discusses some of the best stocks that work with the system.

For instance, BEA Systems(BEAS Quote) has had 21 successes out of 24 occurrences in the past three years, with an average return of 2.35% per trade.

Stockpickr: The 3x2 System

Source: Stockpickr

In addition, we update a portfolio called System Trades of the Day every evening. In that portfolio, we keep track of what we think are the best 3x2 triggers each day. Bookmark that system and you will be notified whenever there's an update.

Another stock that's a particularly good performer in the 3x2 system is Aquantive(AQNT Quote). It has had 183 occurrences with 131 successes, resulting in an average return per trade of +3.89%.

The most recent example of this success for Aquantive occurred on June 8, 2006. You can see in the chart below that the stock went down three days in a row:

aQuantive (AQNT) -- Daily

The stock was purchased after two up days, and the hold time was about a week and a half. The stock was then sold at $26 for a 2% gain.

Another good stock for this system is none other than Google(GOOG Quote).

Here's an example, also from June 2006:

Google (GOOG) -- Daily

Since going public, Google has triggered the system 35 times, with 29, or 82%, successful trades for an average return of +4.27%.