What Is Mean Reversion, and How Do Investors Use It?

Traders can also use the EAs created by others, which can be downloaded from the Market or Code Base tab inside MT4. If there is an uptrend, the price tends to move up from the average and then fall back to it. When the price comes back to the average, this may present a buying opportunity.

Swing trading is a style of trading in which positions are held for several days to weeks, aiming to profit from short to medium term prices. Mean reversion is a key concept in swing trading, helping traders identify potential reversals in price trends. Mean reversion trading can be a very profitable trading strategy when employed with other technical indicators, chart patterns, or candlestick patterns. When a confluence of confirming chart patterns occurs, mean reversion trades can often signal reversals and lead to short-term pullbacks in trends. 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.

Also day traders use RSI and stochastic oscillators for identifying overbought or oversold conditions on an intraday basis. Signals from these technical analysis tools often prompt day traders to enter or exit positions. Additionally, with bollinger bands, day traders look for “squeezes” where the bands tighten, indicating low volatility and the potential for a significant price move. The strategy can be applied across different time periods, from intraday to long-term, and is particularly effective in range-bound or sideways markets.

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Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. This is particularly common with high-risk small-cap companies when they experience a long-awaited catalyst. The mean could even move up to meet the new price – this is also a reversion to the mean because the price is moving up to its new average.

While reversion to the mean occurs regularly, prices rarely stay exactly at the mean for long. The risks of loss from investing in CFDs can be substantial https://www.topforexnews.org/ and the value of your investments may fluctuate. 70% of retail client accounts lose money when trading CFDs, with this investment provider.

In contrast, trend following assumes that prices will persist in the direction they have been moving. Trend followers look to capitalize on the continuation of existing trends, whether upward or downward, without concern for a stock’s intrinsic value. Based on our backtesting result, on average your trades should reach the second target within 1-3 days. The longer you keep your position open, the lower the chances of the trade to succeed. As a general rule, you should cash out of your entire position within the first 3 trading days. Usually, the mean reversion trading strategy has a low DD, but that can be reduced even further.

Is the Mean Reversion a Profitable Trading Strategy?

Trading in the same direction as a strong trend is often referred to as a momentum trading​​; so read more information about this type of strategy. Mean reversion strategies attempt to capture profits as the price of an asset returns to more normal levels, or the average. When considering using a mean reversion strategy in your trading, remember that a price rising away from the mean doesn’t necessarily indicate that the price will fall. That would also constitute reversion to the mean because the price is back in line with its average.

Our best mean reversion strategy is to trade those price ranges that occur after a severe price markup or markdown. In this case, reversion to the mean implies trading around the middle of the range as our average price. The mean reversion trading systems are more appealing to a lot of traders because it tends to have a higher win rate as opposed to the trend following strategies. Even when the markets https://www.day-trading.info/ are in well-established trends, mean reversion happens quite often. Some commonly traded assets well-suited for mean reversion strategies include stocks, forex, commodities, exchange-traded funds (ETFs), and fixed income instruments. A crossover or crossunder of the price and the moving average followed by a significant deviation from the price and the moving average can signal a potential reversal.

1. The strategy also requires active management and can be psychologically challenging, as it often involves going against the prevailing market sentiment.
2. It doesn’t matter to the trader which asset falls or rises, as they seek to profit on the mean reversion.
3. Trend followers look to capitalize on the continuation of existing trends, whether upward or downward, without concern for a stock’s intrinsic value.
4. Some considerations involved in mean reversion involve time horizon and market conditions.

The best timeframe for mean reversion trading can vary depending on the market and the specific asset. However, it is commonly applied to shorter timeframes such as daily or hourly charts. Furthermore, upon using the mean reversion strategy, it is advisable to utilize multiple timeframe analyses. When it comes to mean reversion trading, the use of 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. If moving averages aren’t your thing, channels can be a great way to judge the support and resistance of any trend, vertical or horizontal.

If one asset moves 1% per day and the other asset moves 2% per day, the position in the 2% asset should be half of the 1% asset. This is because if an asset moves more, we don’t need as much of that position to make a profit when compared to an asset that is moving less. One common strategy to consider when forex trading is looking at how far a currency’s relative value tends to deviate from its mean before reverting. Of course, if the pairs move further out of step, then losses will be incurred. Most traders use a stop-loss to limit potential losses for occasions when the strategy fails. If you’re looking to profit from the divergence, you could buy the underperforming forex pair, while simultaneously shorting the stronger pair.

What Is a Mean Reversion Strategy?

Mean reversion is a key element part of how all financial markets work. Obviously, there is also a probability that the price will not revert back to its mean. This can indicate that there is a real shift in the market sentiment and we’re in a new paradigm. The reversion to mean trading system tends to produce a higher win rate in those instances where we can notice extreme changes in the price.

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In parabolic stocks, FOMO is often reaching a fever pitch that is unsustainable. We’ve written an entire post on how to trade trends, so be sure to check that out in addition to the information below. Get tight spreads, no hidden fees, access to 10,000+ instruments and more. IG International Limited is part of the IG Group and its ultimate parent company is IG Group Holdings Plc. IG International Limited receives services from other members of the IG Group including IG Markets Limited. Stay on top of upcoming market-moving events with our customisable economic calendar.

Mean reversion strategies

They are calculated based on the high, low, and closing prices of the previous trading session. Mean reversion 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 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.

Other indicators such as Bollinger Bands®​​ use standard deviation to measure how far away the price is from the mean. The further away standard deviations are from the mean, the more likely the price is to revert to the mean, although that may not happen right away. 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.

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 https://www.forexbox.info/ (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.