Z-Score Signals: Statistical Mean Reversion
Use statistical analysis to identify overbought and oversold conditions for mean reversion trades.
Key Takeaways
- Z-Score measures how many standard deviations price is from its average
- Z-Score ±2 indicates statistically rare overbought/oversold conditions
- Mean reversion works best in ranging markets, not strong trends
- Always use confirmation before entering Z-Score trades
What is Z-Score?
Z-Score is a statistical measurement that tells you how many standard deviations a data point is from the mean. In trading, we use Z-Score to identify when a stock's price has moved unusually far from its average - potential mean reversion opportunities.
Z-Score = (Price - SMA) / Standard DeviationUnderstanding Z-Score Values
| Z-Score | Interpretation | Probability |
|---|---|---|
| > +2.0 | Overbought (above 2 std dev) | ~2.5% of time |
| > +3.0 | Extreme Overbought | ~0.15% of time |
| < -2.0 | Oversold (below 2 std dev) | ~2.5% of time |
| < -3.0 | Extreme Oversold | ~0.15% of time |
Always check the broader trend before trading Z-Score signals.
Z-Score Signals in EMMA
Oversold (Z < -2)
Price is more than 2 standard deviations below the moving average. Statistically, this situation is rare and price often reverts toward the mean.
Overbought (Z > +2)
Price is more than 2 standard deviations above average. The stock may be extended and due for a pullback.
Extreme Low (Z < -3)
Extremely rare oversold condition. Only occurs ~0.15% of the time statistically. High probability of bounce, but may indicate serious problems (bankruptcy, fraud).
Extreme High (Z > +3)
Extremely rare overbought condition. While statistically due for reversion, strong momentum can persist (FOMO, short squeeze).
Breakout (Z > +1.5, rising)
Price is trending strongly above average. This may indicate the start of a new uptrend rather than a mean reversion opportunity.
Breakdown (Z < -1.5, falling)
Price is trending strongly below average. May indicate the start of a downtrend.
- RSI divergence: Price making lower lows but RSI making higher lows
- Support levels: Z-Score oversold at major support is more reliable
- Candlestick patterns: Look for reversal candles (hammer, doji)
- Volume: Capitulation volume often marks turning points
Key Parameters
| Parameter | Default | Description |
|---|---|---|
| Period | 20 days | Lookback for SMA and standard deviation |
| Overbought/Oversold | ±2.0 | Threshold for standard signals |
| Extreme | ±3.0 | Threshold for extreme signals |
| Breakout/Breakdown | ±1.5 | Threshold for trend signals |
Mean Reversion Strategy
- Identify oversold: Z-Score < -2.0
- Check for catalyst: Is there a reason for the drop?
- Wait for confirmation: Look for reversal candles, RSI divergence
- Entry: Buy with stop below recent low
- Target: Mean (SMA) or Z-Score returning to 0
Cautions
- Oversold can become more oversold: Don't catch falling knives
- Context matters: Check earnings dates, news
- Sector analysis: Is the whole sector oversold?
- Trending markets: Z-Score works best in ranging markets
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