MEAN REVERSION
TRADING
STRATEGIES [PDF]
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What is Mean Reversion in Trading?
The Mean Reversion Trading Strategy
Best 5 Indicators for the Reversion to the Mean Trading
Strategy
Mean Reversion VS Trend Following
How to Use Mean Reversion in Trading?
Pros and Cons of Mean Reversion Trading
Mean Reversion Trading Strategies
In the 19th century, Sir Francis Galton popularized the principle of mean reversion, a
groundbreaking discovery in genetics that has since permeated the financial trading
industry. Today, mean reversion trading remains a cornerstone concept among trading
strategies.
Here, you’ll find a comprehensive exploration of mean reversion in trading. You’ll gain
insights into:
The definition and significance of mean reversion in trading.
How mean reversion trading works.
A comparison of mean reversion and trend-following approaches.
A real-time example illustrating a mean reversion trading strategy.
The pros and cons associated with mean reversion Trading.
What is Mean Reversion in Trading?
Mean reversion in trading is a concept that refers to the assumption that asset prices
and historical returns eventually will return to the long-term mean. This concept is
rooted in the statistical phenomenon known as regression toward the mean. Traders
who use this strategy typically look for opportunities to buy or sell assets when prices
deviate significantly from their historical mean in anticipation of their eventual return to
it.
The rationale behind the mean reversion theory is that over time, prices that are
unusually high or low will tend to normalize to their average values. This normalization
can be due to various factors, including changes in market sentiment, economic factors,
or simply the random fluctuations that occur in the financial markets.
For example, if a stock's price has historically oscillated around $50 but suddenly spikes
to $80 without any significant change in the company's fundamentals, a mean reversion
trader might see this as an opportunity to sell the stock, expecting the stock price to fall
back to its historical norm. Conversely, if the stock drops to $20, the trader might buy it,
anticipating a rise back to the $50 level.
And that's the basic idea of using mean reversion strategies - looking for extreme
changes in prices in an asset price with the assumption that prices tend to return to their
average prices.
The Mean Reversion Trading Strategy
Similar to what we’ve mentioned earlier, the mean reversion trading strategy is
grounded in the statistical phenomenon that extreme movements in asset prices are
likely to be followed by a counter-movement, bringing prices back to their average level
over time. So, to effectively employ this strategy, traders must first establish what the
‘mean’ is for their chosen market and time frame.
Now, calculating the mean involves taking an average of the asset's historical prices
over a specific period. This can be done using various tools, such as a simple
spreadsheet to calculate the average manually, a mean reversion indicator that
automates the process, or by visually inspecting a chart to identify the average price
level around which the price has tended to fluctuate.
Once the mean price is established, traders can then watch for significant deviations
from this average. Day traders typically look for intraday price movements away from
the mean to capitalize on quick reversals. In contrast, swing traders and long-term
investors may seek out more pronounced price extremes that occur over days, weeks, or
months, anticipating a more significant move back toward the mean.
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.
As you can see, most of the time, when the price moves towards the overbought or
oversold level, it reverses back to the mean, and as we will see later in this article, these
are where our trading opportunities lie.
What are the 6 Best Indicators for Mean
Reversion Trading Strategies?
When it comes to the mean reversion trading system, the use of technical indicators is
crucial for identifying when prices are deviating from their average and are likely to
revert. Here are some of the best indicators used in reversion to the mean trading
strategy.
1. Bollinger Bands
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.
The mean reversion strategy of the Bollinger Bands indicator revolves around the three
banks of the indicator. Technically, when the price touches or crosses one of the
Bollinger Bands, traders may consider it an extreme deviation from the mean, signaling
a potential reversal point. The closer the price moves to the outer band, the more
overbought or oversold it is considered, hence the higher the chance of reversion.
2. Relative Strength Index (RSI)
The Relative Strength Index is a momentum oscillator that measures the speed and
change of price movements. Typically, an RSI reading above 70 indicates that an asset is
becoming overbought, while an RSI reading below 30 suggests an oversold condition.
Mean reversion traders can use these extreme RSI overbought or oversold conditions to
look for reversal opportunities, buying when the market is oversold and selling when it is
overbought.
3. Moving Averages
Moving averages are clearly among the best indicators to identify indications for mean
reversion. They serve as a smoothed representation of an asset's typical price over a
chosen timeframe and are a foundational tool for identifying mean reversion trends.
Traders watch for deviations from this average: when prices rise significantly above the
moving average, reaching into overbought territory, it suggests an expectation that
prices will drop back to the mean. Similarly, prices that fall below the moving average to
a level considered oversold indicate a potential rebound to the average price.
4. Standard Deviation
Standard deviation is a statistical measurement that sheds light on historical volatility.
By measuring how much the price deviates from its mean, this indicator can help
traders understand the typical magnitude of price movements.
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.
5. Moving Average Convergence Divergence (MACD)
The POC is the price level with the most trading activity within the value area. It functions
as a magnet for future prices and is considered a key reference point. The POC is
typically where the market sees the ‘fairest’ price for the trading session, and it can be
identified as the column with the most letters.
The MACD is a trend trading indicator that measures the momentum and direction of an
asset. It makes use of two exponential moving average lines constantly crossing one
another to give bullish and bearish signals. Mean reversion traders interpret the EMA
lines' growing distance from the midpoint as the instrument deviating from its mean.
6. Mean Reversion Indicator
Some indicators are designed explicitly for mean reversion trading. These include the
Mean Reversion Indicator (MRI), which can help traders identify the point at which an
asset's price has deviated significantly from its historical mean price.
This indicator can be handy in stable markets where prices exhibit consistent patterns of
fluctuation. However, since this indicator is not built-in on popular platforms like MT4, it
requires manually downloading and installing the indicator on MT4/5.
Mean Reversion VS Trend Following
(Momentum) Strategies
When exploring different trading strategies, two prominent approaches stand out: mean
reversion and trend following. Each strategy is based on a unique understanding of
market behavior and offers distinct pathways to profitability.
Mean reversion is predicated on the idea that prices that reach an extreme will revert to
their average value while trend following assumes that prices will persist in the direction
they have been moving.
The mean reversion strategy is best suited for traders who monitor for significant
deviations from historical averages and anticipate a reversal to the norm.
These traders often respond to market overreactions to news or events, which can result
in short-term pricing anomalies. For execution, mean reversion strategies typically
involve tight stop losses and quick profit-taking to exploit these short-term movements.
This approach tends to be more effective in range-bound or sideways-moving markets,
appealing to those seeking quick, short-term profits.
In contrast, trend followers look to capitalize on the continuation of existing trends,
whether upward or downward, without concern for a stock's intrinsic value.
Trend Following
Aspect Mean Reversion
(Momentum)
Prices revert to the mean Prices continue to move
Core Theory
after extremes in the current trend
Capitalize on temporary
Strategy Ride out long-term trends
price extremes
Overreaction to Persistence of price
Market Reaction
news/events movements
Looks for deviation from Focus on trend
Price Valuation
the historical average continuation, not value
Tight stop losses, quick Wider stop losses, longer
Trade Execution
profit-taking position hold
Capture short-term Benefit from significant
Risk Management
movements price shifts
Works well in range- Excels in markets with
Performance
bound markets sustained trends
Short-term, quick profit Patient traders, long-term
Suitability
seekers investment
Sideways, oscillating Bullish or bearish
Market Outlook
markets sustained markets
In sum, the distinction between mean reversion and trend following is not merely
theoretical; it has practical implications for trade execution, risk management, and
portfolio construction. Ultimately, the choice between the two strategies may hinge
more on a trader's personal risk tolerance, investment horizon, and market perspective
than on the inherent superiority of one strategy over the other.
How to Use Mean Reversion in Trading?
Now, let’s take a look at an example of how to trade financial assets using the mean
reversion strategy. For this mean reversion trade example, we will use the intraday mean
reversion strategy.
The difference between the intraday mean reversion strategy and longer-term
strategies is seen in the period of the moving averages used and the selected
timeframe. So, if intraday trading isn't your thing, feel free to tweak the settings to suit
your trading style. Nonetheless, the technique works pretty much the same for any
chosen timeframe.
With that said, we will be using the 50 EMA and the RSI on the hourly time frame in this
example.
Here's a breakdown of how to use this strategy:
Firstly, we use the moving average to determine the mean value of the asset. When
the price is above the moving average, we expect the price to reverse to the moving
average line and vice versa.
After this, we use the RSI as a confluence trading tool to indicate where the price is
truly overbought or oversold. In that case, if the price is above the 50 exponential
moving average and at the same time it is overbought on the RSI, we can quickly
enter a sell position and set our profit target at the moving average.
Let's see what this looks like on a chart:
As you can see from the chart above, based on the mean reversion trading strategy, we
assume that the price will reverse back to its mean reversion; hence, the price returns to
trade closely to the moving average indicator’s line.
About risk management - With these trade opportunities, we always aim to set our profit
targets at the moving average. Also, we can always place our stop loss slightly above
the high when we are selling and below the low when entering a long position.
Benefits and Limitations of the Mean
Reversion Trading
Mean reversion trading is a strategy that can be both rewarding and challenging,
offering unique advantages and potential drawbacks. Let’s quickly see some of the pros
and cons of this strategy.
Pros
Mean reversion strategies often have a high win rate because they capitalize on the
natural flow of price movements around a historical average.
This strategy provides clear criteria for entry and exit points, which can simplify trade
decisions and risk management.
Mean reversion is particularly effective in markets that are not trending strongly in
either direction but are instead moving within a range.
Mean reversion trades are typically short-term, which can result in quick intraday
profits and the ability to compound gains over time.
The rules-based nature of mean reversion trading makes it well-suited for
automation, allowing for backtesting and systematic execution of trades.
Cons
This strategy can be counterintuitive as it involves buying during a falling market and
selling in a rising market, which can be psychologically challenging for traders.
Mean reversion strategies may underperform in trending markets where prices
continue to move away from the mean for extended periods.
Unexpected market events can lead to significant price moves that do not quickly
revert to the mean, resulting in large drawdowns.
To be effective, mean reversion trading often requires constant monitoring and
adjustment of positions, which can be time-consuming.
Is the Mean Reversion a Profitable Trading
Strategy?
From the backtesting results, if done correctly, you can expect to have win rates between
66% and 80%. This level of success rate shows the potential profitability of mean
reversion trading, especially when executed with discipline and proper risk
management.
IHowever, while it offers a lesser risk-reward ratio compared to trend trading, that
shouldn't be a deal breaker, especially if you're a day trader. It simply means that you
won't have to worry about the effect of overnight market movements on your position.
Nonetheless, to answer the question simply: is the mean reversion a profitable trading
strategy? Yes! However, as with any trading approach, a well-considered trading plan is
critical to reaping the benefits that reversion has to offer.
