Rubber Band Trading Strategy

The Rubber Band trading method is a simple but powerful contrarian/mean-reversion stock trading approach that is simple to learn and trade. It seeks to identify points in the market that are overbought or oversold and are likely to revert to the mean. For this approach, some traders utilize Keltner Channels or Bollinger Bands, while others use momentum oscillators.

What is the Rubber Band Trading Strategy?

Experience has proven that the price of a security, like any other time series, has a central tendency. This means that after moving sufficiently away from the mean in any direction, the price tends to revert to it. It is important to note that the price’s tendency to mean-revert is independent of whether it is ranging or trending, and it is unaffected by trend direction. When the price is overextended to the upside or downside in an uptrend, it tends to revert to its rising moving average (moving averages are useful to define the trend). The same thing happens when its moving average falls in a downtrend or is flat in a range market.

To trade this method, you must have a contrarian mindset – as Warren Buffet put it, you must look to buy when the market appears beaten and depressed, and aim to sell when excitement is high and everyone is optimistic about the market. In other words, buying chances arise when there is too much negative sentiment and individuals are losing hope and withdrawing from the market.

Rubber Band Strategy Equity Curve
Rubber Band Strategy Equity Curve

Rubber Band Trading Strategy

The Keltner Channel is a popular indicator for trading this method. The most common configuration is 20 periods with a 10-period ATR (average true range). When the price trades over the upper band of the Keltner Channel, there is a likelihood that it will reverse and fall back to the mean, but in some circumstances, it will fall much lower and reach the lower band. Similarly, if the price falls below the lower band of the Keltner Channel, it is likely that it will reverse and rise to the mean, or possibly go higher and reach the upper band.

When using the Keltner Channel, the buy setup comes when the price is trading below the channel’s lower band. That is, the price bar opens and closes below the bottom channel. To confirm a potential bullish reversal, it may be advisable to wait for a reversal candlestick pattern, such as the hammer or an inside bar. However, like with everything things, this must be backtested. Profit could be targeted in the middle band, which represents the average, or just before the upper band. A sell setup happens when the price is trading over the upper band. A bearish reversal candlestick, such as a shooting star or an inside bar, may aid in the confirmation of a likely bearish reversal. Profit could be targeted in the middle band or immediately before the lower band.

What indicators are appropriate for Rubber Band strategies?

Rubber Band techniques employ indicators that can display the price’s mean values as well as when the price is stretched in the upward direction (overbought) or in the downward direction (oversold). You can utilize the following indicators with this strategy:

Keltner Channel

The Keltner Channel (KC) is a technical indicator composed of volatility-based bands (or channels) placed above and below a moving average. The standard deviation or the average actual range can be used to calculate volatility. Price movement above the upper band indicates an overbought market, while price movement below the lower band suggests an oversold market.

Keltner Channel for Rubber Band Strategy
Keltner Channel for Rubber Band Strategy

Bollinger Bands

Developed by John Bollinger, the Bollinger Bands are a volatility-based technical indicator. It is used to identify overbought (when the price is above the upper band) and oversold (when the price is below the lower band) circumstances in a market.

Bollinger Bands for Rubber Band Strategy
Bollinger Bands for Rubber Band Strategy

A moving average combined with a technical trading oscillator

A moving average is used to illustrate the mean values of prices, while an oscillator is used to determine when the market is overbought or oversold.

Moving Average and Oscillator for Rubber Band Strategy
Moving Average and Oscillator for Rubber Band Strategy

Conclusion

Because the rubber band method is based on mean reversion, it works best with equities. Other assets, such as gold and commodities, are significantly more difficult to trade with these systems.

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