what is mean reversion trading

The longer you keep your position open, the lower the chances of the trade to succeed. As a general rule, you should cash out of your entire position within the first 3 trading days. Usually, the mean reversion trading strategy has a low DD, but that can be reduced even further. To properly identify mean reversion setups you need to use the right technical indicators. A lot of the times when you’re doing mean reversion trading, you’ll be quick in-and-out of a trade.

This is particularly common with high-risk small-cap companies when they experience a long-awaited catalyst. The mean could even move up to meet the new price – this is also a reversion to the mean because the price is moving up to its new average. Plus, while reversion easy markets review to the mean is a regular occurrence, prices rarely stay close to the mean for long. Traders also often use mean reversion analysis as a tool to evaluate stock prices, especially where there is a disconnect between a company’s market cap and its assets.

It’s a good idea to keep in mind that when you’re making your predictions, past performance isn’t a guarantee of future patterns. Mean reversion trading is a strategy that can be both rewarding and challenging, offering unique advantages and potential drawbacks. This indicator can be handy in stable markets where prices exhibit consistent patterns of fluctuation.

what is mean reversion trading

They can define an exit point where their position will close out if the price doesn’t move in their expected direction, helping to minimise losses as much as possible. For more complex algorithmic trading strategies using mean reversion, we also offer trading on the MetaTrader 4 platform (MT4). MT4 allows traders to program their own methods into automated software called Expert Advisors (EAs).

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In this case, you should select a certain moving average level and see how it is performing in a chart. If it deviates deeply from the MA, it is a sign that it will move back to the normal level. Similarly, you can place a short trade when it retests the upper side of the channel and exit when it moves to the mean level. If an asset is substantially above the average, it can be said to be away from its historic average. As such, a trader using this approach will often short the stock, hoping that it will pull back. For example, to carry out a pairs trade, select one of the instruments from the pair that you are interested in.

what is mean reversion trading

For example, stocks are highly mean reverting in the short term, while commodities are much less so. However, the good thing about stocks is that you can successfully apply both momentum and mean-reversion. Moreover, the stock market has many sectors and industries that are not very correlated (business-like). This article gives you some input and advice on how to develop a mean reversion trading strategy and discusses its pros and cons. For example, a day trader will often use a one-minute to a 15-minute chart while an investor will use the daily chart.

Traders can also use the EAs created by others, which can be downloaded from the Market or Code Base tab inside MT4. HowToTrade.com helps traders of all levels learn how to trade the financial markets. When the standard deviation of an asset is high, it suggests that the price movement is more volatile and, hence, may revert to the mean more significantly. From the Nikkei Chart below, using the Bollinger Bands indicator, we can see how mean reversion works in trading. We use the upper Bollinger bands to represent the overbought price level, the middle Bollinger Bands to represent the mean, and the lower Bollinger Bands to represent the oversold level.

Mean Reversion Trading Strategies – Backtest With Mean Reverting Indicators

Whenever stocks make a pullback or correction, there are permanent bears who would claim that it’s a bear market, recession, end of the world, etc. When the 10-period RSI is below 30, it means there’s strong bearish momentum (over the last 10 days). Now, let’s transform this idea into concrete rules which you can use to trade the markets. In other words, if the economy is in a long-term uptrend, the stock market will reflect it. Yes, we have recessions and bear markets along the way but, in the grand scheme of things, the stock market is making a series of higher highs and lows. This is because when two highly correlated pairs move out of standard synchronicity, history suggests they will eventually regress to the mean.

Indeed, some day traders use algorithmic strategies to execute high-frequency trades based on mean-reversion algorithms. As you can see, price frequently pulls away from the blue moving average and then snaps right back to it. Of course, those hindsight-charts with the perfect trades only tell half of the story. Mean reversion trading is often referred to as counter-trend or reversal trading which all, more or less, describe the same type of trading style. A mean reversion trader looks for price that has moved away significantly from its mean (average) price; the mean reversion trader looks for unsustainable trends.

  1. Mean reversion is also used in options pricing to better determine how an asset’s volatility fluctuates along with its long-term average.
  2. Thus, their results would be ineffective against the entire market.
  3. In all cases, they are betting that an extreme level — whether it be volatility, price, growth, or a technical indicator — will return to the average.
  4. Traders can also use the EAs created by others, which can be downloaded from the Market or Code Base tab inside MT4.
  5. Here, the further the standard deviation is from the mean, the more likely the price is to revert.

The best timeframe for mean reversion trading can vary depending on the market and the specific asset. However, it is commonly applied to shorter timeframes such as daily or hourly charts. Furthermore, upon using the mean reversion strategy, it is advisable to utilize multiple timeframe analyses.

#2: 10-period RSI is below 30

The middle line is simply the average price going from the initial point we used to draw the channel till the end. Our best mean reversion strategy is to trade those price ranges that occur after a severe price markup or markdown. In this case, reversion to the mean implies trading around the middle of the range as our average price. In this guide, you’ll learn a mean reversion trading strategy with some trading secrets that will assist you to limit the downside.

Select this product from the Product Library to open a trading chart. Next, in the Product Library, search for the other asset in the pair that you want to trade. A regression line shows a single line that best fits a selected price series.

So, if the RSI doesn’t cross above 40 after 10 trading days, we’ll exit the trade on the open of the 11th trading day. Then focus on buying those stocks which have the highest ROC values as these are the strongest stocks right now and their price is likely to continue higher. You’re more likely to make money buying pullbacks when a stock is in an uptrend (than shorting it). In other words, we only want to be buying when times are “good” and stay on the sidelines during bear market conditions.

Mastering the Markets: Deepening Success Strategic Mentorship and Consistent Trading Practices

The idea behind this mean reversion trading is to capture “one move” in the market, and that’s it. Once your strategy is developed, you can follow the above steps to opening an trade99 review account and getting started trading forex. IG International Limited is licensed to conduct investment business and digital asset business by the Bermuda Monetary Authority.