What Is a Mean Reversion Strategy in Trading?
If you are a forex trader, it’s imperative to understand how the mean reversion strategy works. Most traders have already developed techniques to capitalize on the theory. But, unfortunately, you can’t capitalize on mean reversion if you don’t know the basics.
Traders who participate in mean reversion trading bet that the extreme levels — whether price, growth, or volatility — will turn back to the average. Notably, this kind of trading is more appealing as it tends to have higher win rates than trend trading strategies.
This guide explores the basics of the mean reversion strategy, including a few trading secrets to help you take advantage of mean reversion. But first, we’ll explain what mean reversion trading is and how to customize it to fulfill your needs.
That said, let’s get started.
What Is Mean Reversion?
The mean reversion strategy theorizes that prices tend to move back to the averages as extreme price movements cannot last long. The fundamental principle of this strategy is that it involves selling and buying assets that have shifted from their historical averages.
The bottom line is that the rising or reducing asset prices will return to their previous averages and patterns when the market stabilizes. However, even when a market is in well-established trends, it does not stop mean reversion from happening.
An example of a mean reversion strategy is when you buy a stock with an unusual price fall. When there is a significant drop in prices, the chance is usually high that the price will bounce back to the expected average. In that case, you will make a profit.
Generally, the mean reversion strategy plays around a central value, whether the middle of a range, a moving average, or based on your expression. This approach often produces higher win rates in instances where you can notice extreme price changes.
Now that you know what a mean reversion strategy is, it’s time to look at how it works.
How the Mean Reversion Strategy Works
When you venture into mean reversion trading, you will always be quick to move in and out of the market. It’s why a day trading mean reversion approach works better for some traders. However, there are other ways to trade with the reversion strategy, including the following:
The mean reversion strategy has three major components: entry signal, exit signals, and broad marketing timing. The entry signal alerts traders that prices have moved away from the average price, while the exit signal gives traders a way out after trading.
The primary advantage of the mean reversion approach is that it has an effective exit strategy. That’s because the average price is always the profit target. Also, the mean reversion strategy boasts high win rates due to shorter mean-reversion time frames.
Another advantage of the mean reversion strategy is that it provides good risk-adjusted returns. But just like other trading strategies, it has a few drawbacks. The chances are high that you will first see a loss before a profit when you get into the trade.
Reasons the Mean Reversion Strategy is Effective
The mean reversion strategy works due to the following reasons.
- Prices tend to undershoot and overshoot their intrinsic value. Such price anomalies usually happen when new information hits the market. The market will take some time to absorb and neutralize the impact and establish a fair value.
- Prices tend to move based on collective emotions. So, what does that mean for traders? The prices tend to overshoot downsides more than they overshoot upsides. This is because fear is often a bigger emotion than greed.
What Are the Different Mean Reversion Strategies?
All mean reversion strategies tend to capture as asset prices return to the average or normal levels. However, every time a price moves up from the mean doesn’t mean that it will fall at a future date. The mean could also move upwards to meet the new prices.
Prices rarely stay at the average for long. Here are some mean reversion strategies.
Pairs Trading As a Mean Reversion Strategy
Pairs trading is a potent tool for mean reversion trading since you can bet on the spread between two correlated assets. If the correlation disappears suddenly, it allows you to bet that the correlation will return. That saves you from the risks of outright movements.
An excellent example is when the price of one asset drops and the other doesn’t. That will establish a possible mean reversion trade called statistical arbitrage.
Intraday Mean Reversion Strategy
Intraday trading is the buying and selling of multiple assets within a single day, with the positions often not held overnight. Some traders can use this strategy to trade around a moving average. So, what happens if there’s an upward and downward trend?
If there’s an uptrend, prices tend to rise from the average, then return. When the prices return to the average, it presents an opportunity for more purchases. For that reason, traders often buy more assets when there’s an uptrend in prices.
However, if a downward trend occurs, the prices usually fall below the average then go back to the average. As the prices approach the average, it presents a trading opportunity, allowing traders to take a short position instead (sell).
Factors to Consider to Adopt a Mean Reversion Strategy
Here are the factors that can help traders or investors use the mean reversion strategy.
Traders and investors can use technical indicators such as the relative strength index (RSI) to find highly oversold or overbought assets. These price levels can indicate the entry and exit points for mean reversion trades. Also, you can use Bollinger Bands, Standard Deviation, and Money Flow to locate unusual or extreme price movements.
Before adopting the mean reversion strategy, some investors or traders will look at the financial information like PE ratios and earning reports. For example, if a company has reported higher quarterly earnings than its long-term average, chances are that the next quarter’s earnings will move nearer to the average.
Some traders may also look for mean reversion from economic indicators. If you are among such traders or investors, you need to follow various economic data released every day or month. The economic indicators to watch are gross domestic product (GDP), consumer price index (CPI), and central bank rate decisions.
There’s no doubt that the market reflects the crowd’s behavior. For that reason, some traders often consider sentiment indicators such as investor confidence to determine the turning points. For instance, if 80 percent of investors sell riskier assets like stocks due to a downward trend, it might signal a high level of pessimism in the market.
Using the mean reversion in trading is a potentially profitable strategy, but it doesn’t guarantee continuous profits. What makes the strategy attractive is its simplicity and high win rates. You can also use the mean reversion strategy with several asset classes, such as stocks, currencies, commodities, and cryptocurrencies.