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Can You Trade Polynomial Regression Bands and Standard Deviations?

2 min read

Polynomial regression bands (PRB) have been around for quite a while, though I know of very few traders who use them in earnest. I happen to be a strong advocate of reversion to the mean trading and PRB’s are my primary tool in determining when and how price action reverts to the mean. There are plenty of other bands in trading; Bollinger bands and the Keltner channel come to mind. But for my purposes, I customized the traditional PRB into something that fits my needs perfectly. Of course, the process of refining variables to use with the bands was a long process that lasted several years until I felt comfortable with the product that I now use on an everyday basis.

For anyone who has taken a statistics class, you will know that a Standard Deviation (SD) is a measurement of error. You often see presidential polls state the percentage of voters who favor each candidate and if you read the fine print at the bottom of the page they will state the accuracy of the poll is + or -3%. This means the poll could be 3% wrong on the high side, and 3% wrong on the low side. So much for polling theory.

Traders often overbuy or oversell a security at any given time during the day. When the price becomes too overbought or oversold it generally hits the inner band, which is 2 SD from the midline and things start to change. On certain occasions, price action might well reach 3 SD. When the price gets that far out of line, another group of traders springs into action. These traders are called arbitrage traders and they profit by trading the security against a related security. The result is usually a return to the midline for the overbought or oversold security; hence, the term reversion to the mean. This trading behavior is especially prevalent on the ES contract where there is literally an army of arbitrage traders.

You can see now that reversion to the mean trading is the result of several trading processes. Polynomial regression bands are my attempt to quantify this complicated chain of events and quantify when the price will move to the mean. It is a very accurate method of trading. I record every trade I make and indicate the type of entry I used to enter the trade. The reversion to the mean trades have a 79% chance of moving 6 or more ticks in profit, usually much more. Yet this style of trading is generally overlooked in the retail trading ecosphere. I have no idea why.

David S. Adams

All content in this article is for informational purposes only and in no way serves as investment advice. Investing in cryptocurrencies, commodities and stocks is very risky and can lead to capital losses.

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