Monday, July 13, 2009

Markets are mean reverting in the long run

This is my fourth post for the weekend. The previous three posts are:
green-shoots-may-be-turning-brown
worries-about-proprietary-trading
closed-room-and-chart

I also have a new post in the 'Practical Technical Analysis' section :
lessons-in-technical-trading

This post on Monday Morning considers the nature of mean reversion. This theory says that prices eventually move back towards the mean or average. This mean or average is usually the historical average of the price.

I feel that mean reversion is justified in a long term scenario. But, momentum controls the short term. As an example, Nifty has fallen from 4480 to 3970 in five days, an outsized decline. Mean reversion may well say that a rally should come. That is dangerous thinking. Markets in the short term are controlled by momentum. If sellers dominate, this decline can continue for far longer than we assume. The same happens in runups when markets keep on going up, refusing to retrace.

1 comment:

gofi said...

Hi Sudarshanji,

Nifty has corrected by 800 points without creating a single GAP on the downside. How do we understand this fact.

1. Does this mean that this downtrend is not a strong trend.

2. Or Does this mean that the GAPs are preserved for the worst news to come :)

i am inclined to believe option 2. Kindly let me know your thoughts.

Thanks,
Gofi