Mean Reversion Trading: Best Indicators and Trading Strategies

Bollinger Bands are among the most popular indicators for mean reversion traders. Created by John Bollinger in the 1980s, these bands consist of a middle band in a simple moving average (SMA) and two outer bands that are standard deviations away from the SMA. The standard setting is a 20-day SMA with the outer bands set at two standard deviations above and below. So, to effectively employ this strategy, traders must first establish what the ‘mean’ is for their chosen market and time frame.

• You can see on the chart below that I’ve got a 3-period plotted RSI on the chart.
• Also day traders use RSI and stochastic oscillators for identifying overbought or oversold conditions on an intraday basis.
• Still, this isn’t enough to signal a short trade, as the MACD is notorious for given false divergence signals.
• This principle has given rise to various trading techniques and models.
• So, as with all things in trading, know your limits before diving in.

If you want to stay in the game and avoid massive drawdowns, then using leverage in large position sizes in mean reversion is something you want to avoid. nfp forecast Use wider stop losses in mean reversion to avoid your win rate dropping and your expectancy falling apart. Trading in futures involves a significant risk of loss and is not suitable for all investors. A trend follower wouldn’t prematurely declare a new trend but would instead wait for it to solidify, the same patience and strategy apply to reversal trading. You’ll notice that the buy signal was a breakout of the smaller congestion area following the drop.

Traders watch for when prices hit the channel’s edge and trade with the expectation of a return to the channel’s median price. This can be observed in stock market trends where prices oscillate within established support and resistance levels, providing potential entry and exit points for mean reverting strategies. A mean reversion trading strategy is based on the assumption that asset prices will revert to their historical average. Traders use statistical measures and technical indicators to identify these reversion points.

How do you screen for mean reversion stocks?

Both hedge funds and mutual funds have mandates on how to operate, both on risk parameters and diversification. Thus, they are obligated to reshuffle their portfolio, which is often against the prevailing trend. The theory of mean reversion is focused on the reversion of only relatively extreme changes, as normal growth or other fluctuations are an expected part of the paradigm.

Best Mean reverting trading strategies

IG International Limited is licensed to conduct investment business and digital asset business by the Bermuda Monetary Authority. Stay on top of upcoming market-moving events with our customisable economic calendar. This is because when two highly correlated pairs move crypto rocket broker overview out of standard synchronicity, history suggests they will eventually regress to the mean. One of them has sold 30,000 copies, a record for a financial book in Norway. This is also called the law of large numbers, an essential concept in trading.

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Each of these has its own specific formula for finding out when an asset’s price is at its extremity and may revert back to the mean. As a caveat, no matter how sophisticated, these signals can only be used as possible indicators of where an asset may move. It depends – you can’t expect to make money with a universal strategy. Mean reversion works excellent for stocks but not for commodities where trend following works much better. Over the past 200 days, the stock of Company XYZ has had an average closing price of 50.

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They can use strategies like the Iron Condor, which capitalizes on a stock remaining within a certain price range. Revenge trading is a high-risk and impulsive trading behavior that usually happens due to an attempt to recover the losses from earlier trades, thereby resulting in further losses or capital depletion. Remember, mean reversion strategies, like any trading approach, carry risks and may not always perform as expected due to changing market conditions. It’s crucial to remain adaptable and continuously assess the strategy’s effectiveness. Mean reversion theory suggests that, over time, the stock price of XYZ Inc. is likely to revert toward its long-term average of $50. Investors employing mean reversion strategies would view this deviation as an opportunity.

However, you’ve got to be cautious because if you’re paying too much in commission or getting too much slippage on your orders, or late in your trade execution, it can erode the system’s profitability. The small average profit per trade means in mean reversion trading you must have excellent attention to detail and precision. I’m a fairly laid-back and considered person, I want a manageable amount of activity, and take only a few trades every day. When I was trading manually, the activity level was a real disadvantage for mean reversion for me. I naturally preferred long hold times, buy now, and sell several months after capturing a major trend. Mean reversion is excellent for people who like a bit of action, want to hold on for a short time, and want to confirm whether the trade was a winner or a loser quickly.

If you look at the price, the price tends to move above the average and then snap back in an uptrend and bounces back. And then in a downtrend, it moves down and intends to snap back, then moves down again, and tends to snap back. A short entry upon the breakout of that candle with a stop loss above the highest high would have been the smartest way to fade this market.

Traders observe when prices deviate significantly from the mean and anticipate a reversal. The strategy is commonly applied to short-term trading methods like swing trading and day trading. Here, you are trading based on price action, rather than indicators.

Look for a buying opportunity when the price goes below the lower band and aim to close your position once the price crosses the middle band. Your entry trigger may be a reversal candlestick pattern like the hammer. When a stock’s price is rising, investors and traders, most of whom are inexperienced, rush to coinberry review buy the stock so as not to miss out on the opportunity.

Is mean reversion better than trend following?

This creates a situation of higher demand than supply, which causes the price to shoot up further. As the price continues to rise, more traders are greedily buying the stock, until it reaches a point where the early buyers start selling. Mean reversion trading is a method of trading where you try to capture correctional price moves after the price has moved significantly away from its mean. And yes, mean reversion strategies work very well in swing trading. Practically, you could enter a short position if the price increases above a common reversal level on the PPO and then drops below this level, with the target placed on the mean. To manage risk, a stop-loss would usually be placed slightly above the already-high entry point to cover the risk of loss in the event that the price continues to move away from the mean.

• Mean reversion differs slightly from other trading strategies in how you combine a system’s various components.
• The oversold reading in the RSI made for a perfect entry point to catch the rally.
• A high standard deviation means prices are spread out over a large range, while a low standard deviation indicates prices are clustered closely around the mean.
• If you use a tight stop loss, what happens is many of those small gains will turn into losses because they often move against you before they bounce.
• Create and maintain a trading schedule, which will ultimately become a habit and influence how you place trades in the market.
• They do come suddenly, and you’ve got to make sure you manage your exits carefully to keep that significant loss contained.

One way to accommodate the big stop loss is to reduce your trade size to a level where the big stop loss will still be within your acceptable account risk. Opposite, the lower the readings, the more likely it gets with a trend reversal in the opposite direction. We have covered many of these indicators and included examples and strategies in the articles.

Technical indicators are pivotal in this strategy, aiding traders in making educated decisions. Successfully applying mean reversion requires a deep understanding of market forces, a robust trading plan, and adapting strategies based on market conditions. An example of mean reversion can be seen when a stock’s price deviates significantly from its historical average or moving average. If the price moves far above this average, the mean reversion theory suggests it will likely move back towards the average in the future. Moving averages are a fundamental tool used in mean reversion strategies.