Taking a contrarian perspective can often be the right strategy with commodity markets. Taking the maxim ‘the cure for high prices is high prices’ and its antithesis then there will come a point in any market that momentum reverses and prices return to (or at least towards) the mean.
In this post we introduce one way of calculating the potential for mean reversion that uses the z-score. A z-score is simply the number of standard deviations separating the current price from the mean price. The strategy then looks at the momentum of the average z-score and takes a contrarian approach to trading to generate buy and sell signals. If the z-score is positive, it means that the current price of the security is above its mean. Correspondingly, if the z-score is negative, the current price of the security is below its mean. Although most trading packages calculate it, click here for how to calculate it in excel.