Mean Reversion Trading Strategies

However, like other trading approaches, it also has some of its drawbacks as we have described above. In the chart below, we see that the SPY ETF is in an overall bullish trend. In this case, the mean reversion approach suggests that the price will often pull back and retest this support level. The other approach for trading the mean reversion approach is to use support and resistance lines.

As stocks go up and down they become more liable to rebalancing, and this means selling those stocks which have risen and buying those which have fallen. This information has been prepared by IG, a trading name of IG US LLC. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion.

1. Swing trading aims to capture individual price swings, and you can achieve that with a mean reversion strategy.
2. The Relative Strength Index is a momentum oscillator that measures the speed and change of price movements.
3. This channel is drawn by connecting several levels of support or resistance.

Prices can continue moving away from the mean for longer than expected. Also, trend direction may change, or how much or how little the price moves may change. Just because a price has risen doesn’t mean it will fall to the mean; the mean could also rise to meet the price. A mean reversion trading system requires a trading platform​​ with mean reversion tools, such as regression lines, moving averages, MACD or PPO indicators, and the ability to compare assets for pairs trading. On the EUR/USD chart below, the PPO is used to show how the closing price (1 period) compares to the 21-day average price. The black trendlines​ mark common areas where the price reverted back toward the mean.

A support line is one that connects several low points of an asset while the resistance connects several high points. The first step of calculating mean reversion is to get an asset’s historical data for a certain period. In this case, the mean reversion approach suggests that the price will gravitate towards the mean price of the chart. However, as the chart shows, at times, the price might deviate from this mean, for several reasons. In this period, the price is oscillating between the middle line of the regression channel. The most common regression approach is known as the Raff regression channel, which is based on linear regression.

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You could sustain a loss of some or all of your initial investment and should not invest money that you cannot afford to lose. When the prices deviate from one another; for example, one drops when the other doesn’t; this creates a potential mean reversion trade. As the asset approaches the mean, it’s your goal to determine the strength of the pullback and the broader context of the stock or stock market.

Once your strategy is developed, you can follow the above steps to opening an account and getting started trading forex. So, to make things simple, we will walk you through 5 easy steps for identifying the pattern. In this example with TSLA, we see a sharp decline that wasn’t sustainable in the morning trading session. After confirming 3 bullish reversal candles and a gravestone doji, TSLA marched right back to the VWAP in red. Notice how the first image in white background is following a steady trend upward. In parabolic stocks, FOMO is often reaching a fever pitch that is unsustainable.

In essence, it suggests that severe deviations from the mean are not sustainable long-term, and prices are apt to return to their average values eventually. Mean reversion is a key concept in trading theory which posits that prices tend to return to average levels, as extreme price moves – both up and down – are hard to sustain for extended periods of time. Mean reversion https://broker-review.org/ is a financial theory that suggests asset prices will eventually return to their long-term mean or average. This concept is grounded in the belief that asset prices and historical returns will gravitate toward a long-term average over time. The greater the deviation from this mean, the higher the probability that the asset’s price will move closer to it in the future.

Mean Reversion in Different Markets

Short-term traders may use intraday data, while long-term investors may use yearly data. Traders may also use other volatility indicators, such as historical volatility or implied volatility of individual stocks or other financial instruments, to identify potential mean reversion opportunities. In this article, we’ll explore the basics of mean reversion trading, including how it works, common strategies used by traders, and the advantages and drawbacks of this approach. Whether you’re a novice or experienced trader, understanding mean reversion strategies can help you navigate the markets with greater confidence and potentially improve your returns. One thing about using a mean reversion strategy for swing trading is that the win rate can be quite high, making it easier to execute your trades when you see a setup.

Mean reversion forex trading strategy

Read more about our charting features​​, which include a wide range of technical indicators and drawing tools. The regression (middle) line highlights the dominant trend and the price tends to move around it. The upper and lower lines mark the furthest points that the price has moved from the regression line.

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What we’re looking for is for the price to reverse back to the 10-period SMA strategy. Put it simply; mean reversion trading assumes that over time the prices of any asset (stock, commodity, FX currency or cryptocurrency) in time will revert back to the mean or average price. It accentuates buying strength and selling weakness, allowing traders to ride the prevailing trends, whether upward or downward. HowToTrade.com takes no responsibility for loss incurred as a result of the content provided inside our Trading Academy. By signing up as a member you acknowledge that we are not providing financial advice and that you are making the decision on the trades you place in the markets. We have no knowledge of the level of money you are trading with or the level of risk you are taking with each trade.

When the demand exceeds supply, the stock rises again, and the cycle continues. Meanwhile, more traders are lured in, greedily buying the stock as the price continues to rise; this continues until the price reaches a point where the early buyers start selling to secure their profits. Up to that point, the demand-supply balance has been in the favor of demand, but that is now changing, as more people are willing to sell to take profits. As one should expect, when there is more supply than demand, the price begins to decline. Practically, a trader 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.

Consider a scenario where a trader meticulously studies various stocks, aiming to find those that display mean reversion opportunities. The trader spots Alphabet (GOOG), exhibiting stable price movements historically but currently showing substantial deviation from its historical mean price. Another substantial risk emanates from relying on historical mean prices, which may lose relevance due to evolving market conditions, leaving traders to contend with outdated benchmarks. Distinguishing between transient market noise and genuine trading opportunities is also crucial to avoid misguided trading actions. Diversification is key, mitigating risk by spreading it across diverse assets or markets. Calculating mean reversion demands a meticulous and analytical approach, using statistical measures to pinpoint times when prices are significantly deviated from their expected average or mean.

If there is a downtrend, then the price tends to fall below the average and then rally back to it. When the price is near to the average, this may present an opportunity to take a short position (sell) instead. As you study your mean reversion strategy, be sure to take simulated trades and then qualify your stats in our analytics page that is built-in. The more success you have, the more confidence you’ll have in trading the mean reversion strategy in a real market environment. As the trend accelerates, you notice that the stock becomes extended from the 9-ema on a 1-minute chart. It then produces a large red bearish engulfing candle that stops the upward momentum, leading to two lower highs on the backside of this trade.

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Percentage returns and prices aren’t the only measures considered in mean reverting; interest rates or even the price-to-earnings (P/E) ratio of a company can be subject to this phenomenon. Another one is that even though we can use certain indicators and price patterns to estimate an exaggerated price move, there is no way to know for sure where the price would reach and revert to its axitrader review mean. Mean reversion should demonstrate a form of symmetry since a stock may be above its historical average approximately as often as below. Many asset classes, even exchange rates, are observed to be mean reverting; however, this process may last for years and thus is not of value to a short-term investor. Keep in mind, leverage means you can gain or lose money faster than expected.

With this strategy, you simply count the number of days the market consecutively closed lower; three consecutive downward closes are commonly used. Discover how to increase your chances of trading success, with data gleaned from over 100,00 IG accounts. We did a backtest of the most important mean reversion indicators recently (see link below). This means that mean-reversion and trend-following require entirely different mindsets, risks, and drawdowns. In Gregory Zuckerman’s unauthorized book about Jim Simons, Zuckerman claims that the managers of the highly successful Medallion Fund consider mean revertive strategies as the “low-hanging fruit”. Any data or observations that are on the tails of a normal distribution are most likely abnormalities that will sooner or later turn around a revert to mean.