Mean Reversion Trading

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Mean reversion trading is a strategy in the financial world, especially in quantitative trading and algorithmic strategies. This approach is based on the idea that asset prices go up and down around an average value, and over time, prices tend to go back to this average. Essentially, prices revert to the mean.

Table of Contents

What Is a Mean Reversion Trading Strategy?

Traders who use mean reversion strategies find assets that have strayed significantly from their typical average prices and make trades with the belief that prices will eventually return to their average.

It involves statistical analysis, technical indicators, and quantitative models to find trade opportunities that profit from the anticipated return to the mean price level.

Using Mean Reversion In Day Trading

Intraday traders look to capitalize on short-term price changes, including those caused by mean reversion. Day traders can exploit short-term mean reversion opportunities by spotting intraday deviations from the average price.

Using Technical Analysis In Mean Reversion Trading

Mean reversion trading can apply various technical indicators. Some of these technical indicators include Bollinger Bands, RSI, moving averages, and MACD (Moving Average Convergence Divergence). Why do indicators help? Traders use these indicators to detect stretched price movements and possible mean reversion chances.

Let’s take a look at a few of the indicators below:

Moving Averages

Moving averages are used to identify assets switching up from their average price in mean reversion trading. Another way to say it is, moving averages smooth out price data over a specific time, visually representing the average price.

Traders use moving averages in mean reversion strategies in the following ways:

Identifying overbought and oversold conditions: Moving averages help traders determine whether a stock has deviated significantly from its mean. If the price moves too far from the moving average, it may indicate an overbought or oversold condition. It may be safe to assume the price will likely revert to its mean.
Confirming reversals: A crossover occurs when the shorter-term moving average crosses the longer-term moving average. Furthermore, this indicates a possible reversal in price direction. Hence, traders may look for a crossover of shorter-term moving averages (e.g., 10-day or 20-day) with longer-term moving averages (e.g., 50-day or 200-day) as a confirmation of a potential mean reversion opportunity.
Determining entry and exit points: Moving averages can help determine when to buy or sell. Traders might buy an asset when its price significantly differs from the moving average and sell when it returns to or near the moving average.

Bollinger Bands

Bollinger Bands are frequently used in mean reversion trading to recognize potential trades. How do these bands form? There’s a center line, which represents a moving average, and upper and lower lines that are determined using the standard deviation of price changes.

In mean reversion trading, we use Bollinger Bands in the following ways:

Identifying overbought and oversold conditions: When the stock price reaches the upper band, we assume the stock is overbought. Alternatively, an oversold stock could occur when the price reaches the lower band. Many traders consider these extreme conditions potential signals for a mean reversion trade, expecting the price to return to the middle band.
Confirming price reversals: Traders frequently observe price action when the stock price touches or crosses the upper or lower Bollinger Bands. If the price reverses following contact with the band, it can confirm a mean reversion trade signal, suggesting that the price may return to the middle band.
Volatility assessment: Bollinger Bands also provide information about the market’s volatility. When the bands squeeze closer, volatility decreases. While expanding bands indicate increasing volatility.

Relative Strength Index (RSI)

The Relative Strength Index measures the strength of a stock and identifies overbought or oversold conditions.

In mean reversion trading, use RSI in the following ways:

Identifying overbought and oversold conditions: Traders assess RSI values to determine when an asset might be overbought (RSI values above 70) or oversold (RSI values below 30).
Confirming potential trade entries: Mean reversion traders can utilize RSI to validate their trade entries when combined with other indicators or signals. For instance, if an asset’s price touches the lower Bollinger Band and the RSI is in oversold territory, it may provide a stronger indication for a mean reversion trade setup.
Generating trading signals: Some traders devise specific RSI-based mean reversion trading strategies. For example, wait for the RSI to cross above a certain threshold (e.g., 30 or 40) from oversold levels as a signal to buy, anticipating a price rebound. Conversely, a crossover below a specific RSI level might signal a sell opportunity.

Stochastic Oscillator

When trading with mean reversion, the Stochastic Oscillator finds potentially overbought and oversold situations in an asset. The Stochastic Oscillator has a few uses for mean reversion trading:

Spotting overbought and oversold levels: It compares the current stock price to the price range over a set period. It gives two lines, %K and %D, which go between 0 and 100. If the %K line crosses above the %D line and moves above a certain level (e.g., 80), it suggests the asset is overbought. Conversely, the asset is oversold if the %K line crosses below the %D line and moves below a specific level (e.g., 20).
Confirming potential trade entries: Traders can use the Stochastic Oscillator to confirm entry points for mean reversion trades. For example, if an asset’s price touches the top Bollinger Band and the Stochastic Oscillator is in overbought territory, it can increase the chance of a mean reversion trade setup.
Generating trading signals: Traders can create specific trading signals based on the Stochastic Oscillator. A common approach is to wait for the %K line to cross above or below specific threshold levels (e.g., 20 and 80) as a signal for entering or exiting a mean reversion trade.

Moving Average Convergence Divergence (MACD)

MACD is a commonly used tool in trading to identify potential overbought and oversold conditions. Traders often use the MACD to spot momentum shifts and potential mean reversion points by comparing two moving averages of a stock’s price.

When the MACD line deviates significantly from the zero line, it may suggest that the asset is overextended and could revert to its mean. These conditions are opportunities for traders who expect the price to readjust.

In most MACD calculations, the difference between the 12-period Exponential Moving Average (EMA) and the 26-period EMA creates an oscillator centered around zero. As a result, this makes the MACD a common indicator for identifying overbought or oversold conditions in mean-reversion systems.

Mean Reversion Trading Benefits

Mean reversion trading offers many benefits! You can profit from short-term price movements, which allows traders to capitalize on overextended price levels.

Mean reversion trading is flexible and applicable across all asset classes. It provides a structured trade approach and uses statistical analysis to identify trading opportunities.

In range-bound markets, where prices fluctuate in a range, mean reversion strategies can be profitable. It’s less effective in trend-following strategies.

Mean Reversion Drawbacks

Mean reversion trading has its downsides, including:

the possibility of extended deviations from the average,
increased costs if you’re actively day trading the security.
strong risk management is needed to prevent major losses during prolonged price movements.

Key Questions

Is The Market Strongly Trending? In strongly trending markets, mean reversion is less reliable because prices may not return to the average for long periods.
Is There A Lack of Direction In The Market? Mean reversion is non-directional, unlike trend-following strategies, which may not be suitable for all trading styles.
Do You Know How To Identify False Signals? In particular, shorter time frames are vulnerable to market noise, which may lead to false mean-reverting signals.
Are there any upcoming economic events? Sudden economic developments or unexpected news can interrupt mean-reverting trends and potentially result in financial losses.
What Are Your Trading Costs? Frequent trading is part of mean reversion trading strategies, increasing transaction costs. Hence, be aware of what your broker is charging you.

Key Takeaways

Traders capitalize on the assumption that asset prices fluctuate around a long-term average or “mean” and eventually revert to this mean.
Mean reversion trading strategies are non-directional, so it’s the opposite of trend-following strategies
Traders may use statistical tools, technical analysis, and quantitative models to identify mean reversion trades.
Traders often combine moving averages with other indicators, such as MACD, RSI, or Bollinger Bands, to gain further insights and improve the accuracy of mean reversion signals.
In strongly trending markets, mean reversion is less reliable because prices may not return to the average for long periods.

Best Mean Reversion Asset and Timeframe

The best time frame for mean reversion trading depends on what you’re trading and your strategy. In a nutshell, it’s highly subjective. Different assets show mean reversion behavior over various periods, so the choice of time frame can significantly affect the success of a mean reversion approach.

For example, some traders have found that the 10 and 20 EMAs work best in the four-hour and daily time frames. Shorter time frames, such as 15-30-minute, or hourly intervals, are also commonly used in mean reversion strategies due to the frequent price fluctuations within these periods.

What is the best asset for trading using mean reversion? The best part about mean reversion trading is that the strategies work on anything. From stocks to commodities to forex, you can try your hand at using any of them!

Final Thoughts: Mean Reversion

Mean reversion is different than trend trading strategies. Trend-following aims to capitalize on assets moving strongly in a particular direction. Mean reversion aims to capitalize on price deviations from an established mean or average.

Prices tend to gravitate to their mean or average. Extreme price fluctuations are only temporary. Prices will eventually go back to their long-term average levels. This concept underpins mean reversion trading strategies, which aim to profit from such price movements.

Frequently Asked Questions

What Is an Example of Mean Reversion?

One example is using technical indicators such as Bollinger Bands or the Relative Strength Index to find overbought or oversold stocks.

What Is a Mean Reversion Strategy

A trader who uses the mean reversion strategy looks for assets that are either significantly overvalued or undervalued. In other words, they have moved away from their average price levels. Next, traders take positions based on the expectation that stock prices revert to their mean or average.

Is Mean Reversion Profitable?

Yes, it can be. However, it depends on your skill as a trader to identify overbought and oversold conditions. The best part about it is that the strategies work on anything. You can try using any of the strategies from stocks to commodities to forex.

What Is the Mean Reversion Process?

Traders often combine moving averages with other indicators, such as MACD, RSI, or Bollinger Bands, to identify overbought or oversold stocks.

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