One of the most critical variables in trading, particularly when it comes to mean reversion strategies, is being able to approximate how sustainable a move is based on the rate of change of a stock’s price.
Yes, the slope of a stock’s price over time is important — but even more important is essentially the derivative of that. The rate of change in price is what usually determines whether a move is sustainable or not.
Understanding the Slope
A slope of zero means the stock is consolidating.
I almost never want a position inside a consolidation when the slope is around zero.
I also almost never want to counter a trend when the slope is steady — for example, a slope of negative one or positive one.
The corollary of that is if I’m long and a position is steadily increasing, then I often have no reason to sell.
There’s no price target that will make me sell if we are steadily and sustainably increasing.
It surprises many traders to hear that there is literally no specific dollar amount or percent move that will make me interested in a stock.
Oftentimes, traders around me would be shocked to find that I avoided some trap or wasn’t fighting a trend on a big move — when what always kept me safe was internalizing that it isn’t so much about how big a move is, but how it gets there.
The Waterfall Effect
What I’m really looking for in my mean reversion strategies is what I like to call a waterfall.
As you can picture it, a stock will start to decrease — but that rate of change then increases, and it essentially starts to create an asymptote.
For those who don’t recall high school math, that’s just the smart-person way of saying the stock is melting and in freefall.
Visualizing Different Scenarios
- Slope of Zero (Consolidation)
A stock that’s range-bound.
I do not want to initiate trades here.
If I were to get long or short, I’d wait for the stock to break out above the range to go long, or break down below to get short. - Steady Positive Slope
If I’m long, I have no reason to sell.
Certainly, no reason to be short or fading this move. - Steady Negative Slope
If I’m short, I have no reason to cover.
Certainly, no reason to be long and fading this move. - Capitulating to the Upside
Rate of change is everything here.
If I’m long, I’m selling into this cap situation — and independently, I might consider a short. - Capitulating to the Downside
If I’m short, I’m covering into this capitulation — and independently, I might consider a long.
The Implications
Understanding what a sustainable versus unsustainable rate of change looks like helps in so many ways:
- It helps you hold onto your with-the-trend positions longer.
- It helps you avoid fighting the trend on sustainable moves.
- It allows you to identify high-probability retracements for mean reversion opportunities.
Bringing It All Together
In isolation, each of these concepts is useful — but where the magic really happens is when you combine them.
As you might imagine, this topic runs hand in hand with the Right Side of the V concept, as well as the lessons on various ways to measure overextension.
Mastering these ideas — and then implementing them holistically — is what creates real edge.
