Monday, November 06, 2006

Regression to the Mean

The one area of TA that I can't fault (aside from pure old supply and demand) is the theory regarding regression to a mean. I've seen it so many times that I know it is the truth - when one average strays far enough away from another average the other average acts as an attractor and pulls it back. The same thing could be said about raw price but raw price is so volatile most often that you will have a difficult time trying to figure it out.

Above is a picture of IWM, the black line is the normalized returns over the period selected, the yellow line is the 4 period average of the black line and the red line is the 20 period average of the black line. You don't have to be a rocket scientist to be able to figure out why IWM closed up on Friday - it was getting too far away from its 20 day average. Now the only problem with that statement is - how far is too far? Well we really don't know - all we can really say is that given 2% difference between averages price is going to react - most of the time. And you can take that to the bank.

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