Mean Reversion Trading What Is It And How Do You Trade It?

Traders use support, resistance levels, and historical price averages to determine potential entries and exits. When security is oversold, it has moved substantially below its historical mean, whereas an overbought condition suggests the opposite. A reversion strategy posits that these deviations are temporary, and a correction towards the mean is likely. Bollinger Bands are frequently used in mean reversion trading to recognize potential trades.

Mean Reversion Trading Strategies

Channels, defined by upper and lower bounds, represent the typical range within which the stock price fluctuates. 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.

To have a complete trading system you need the setup, entry, pyramiding, exit, and initial stop loss, and the portfolio management, risk management, and position sizing rules. For mean reversion, each of these requires a certain style or method of thinking to get the system right and ensure it’s profitable. A regression is simply another way of measuring what normal looks like. The chart above shows that the price tends to return to “normal” levels, which in this case is the regression line. Read more about our charting features​​, which include a wide range of technical indicators and drawing tools. Mean reversion means the tendency of a dataset to revert toward the mean after moving significantly away from it.

Selecting Optimal Sparse, Mean Reverting Portfolios

When the asset’s price deviates significantly, a reversion is expected. Think about an elastic band — we know that stock prices tend to move in trends, but those trends are not a straight line. The price will oscillate above and below the trend, and when the price moves below the trend, it’s like an elastic band being stretched which tends to snap back. When the price moves above the trend, it’s like the elastic band being stretched in the other direction, and it will tend to snap back. This is precisely the behaviour that your mean reversion trading strategy is looking to capitalize on. An overbought market occurs when the current price is significantly higher than the average price, while an oversold market is when the current price is significantly lower than its average price.

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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.
• If you like a lot of activity and trades to keep you interested, reversion trading is a powerful way to make money in the markets.
• Yes, we work hard every day to teach day trading, swing trading, options futures, scalping, and all that fun trading stuff.
• What I want to demonstrate now, is a simple set of indicators that give you a feel for how these trading strategies work on the chart.
• An intraday mean reversion strategy works best when a strong trend is present, combined with a moving average where the price tends to get near it and then moves in the trending direction.
• To go short the market using a mean reversion strategy we are looking for a point on the chart where there’s a downtrend in place, and the two-period RSI is extremely overbought.

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. On an asset’s trading chart, the mean python exponential is easily represented by a simple moving average (SMA). Over time, prices tend to oscillate around the average or SMA, eventually returning to it.

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The primary trend is super important because if we trade in the direction forexee of the primary trend, we tend to have a higher average profit per trade. If we look at the chart below, we can see that while it’s in an uptrend, the RSI two got down to as low as 1.7, which is quite oversold. Therefore, we’ve got strong down movement, you get in and then have a couple of days of rally. Meanwhile, the mean price of the stock lies somewhere between the two extremes.

Mean-reversion trading using the moving average indicator

If you are going to engage in any trading activity with Futures on Virtual Currencies including Bitcoin, please view NFA & CFTC advisories providing more information on these potentially significant risks. Finally, it is important to set stop-loss orders and profit targets. Never overexpose your capital by investing too much in a single trade. 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. Fortunately, the trendline break coincided with a decline in the stochastic reading as well. The example above shows exactly what Bollinger Bands are designed to indicate.

So, at that significantly lower price, traders and value investors would consider the stock underpriced (undervalued). Expectedly, they start buying the stock again, increasing the demand for the stock. 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 review the no-spend challenge guide one should expect, when there is more supply than demand, the price begins to decline.

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. Mean reversion is a useful market concept to understand, but it doesn’t assure profitable trading. While prices do tend to revert to the mean over time, we can’t know for sure, in advance, when that will happen.

One of the great things about the Canadian market and trading volatile stocks is that you get much better average profits per trade than in some other markets. You’re probably thinking, “Oh, this is an S&P 500 stock system right? ” And, no, it’s not because many mean reversion trading strategies, particularly ones that enter at the open, have lost their edges in the S&P500 stock universe in recent years. They have decayed over the last decade or so at the top end of the US markets. There are still mean reversion strategies that work in those markets.