what is mean reversion trading

Consider a mean reversion situation involving the stock of Company XYZ.

Because of these unknowns, most professional traders have strict risk-management​​ protocols. They can define an exit point where their position will close out if the price doesn’t move in their expected direction, helping to minimise losses as much as possible. A regression line shows a single line that best fits a selected price series. The Raff (regression) tool on our trading platform can be used to plot this line for traders.

So, to effectively employ this strategy, traders must first establish what the ‘mean’ is for their chosen market and time frame. One of the best ways to find a target for https://www.dowjonesanalysis.com/ a mean regression trade is to use not only the moving averages but also VWAP. VWAP is a measure of the volume-weighted average price of a stock on an intraday basis.

Traders and investors use mean reversion for timing of their respective trading and investment strategies. Trades can use various metrics, such as distance from the SMA, to help to establish when the price could revert back to the mean. However, as always in trading, these can only provide signals and are not a clear indication of reversal. On an asset’s trading chart, the mean is easily represented by a simple moving average (SMA). Over time, prices tend to oscillate around the average or SMA, eventually returning to it.

  1. 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.
  2. Nonetheless, the technique works pretty much the same for any chosen timeframe.
  3. 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.
  4. Often a mean reversion will occur when asset prices become extended in either direction.

Once you’ve grasped the basics, there are many further technical indicators to help hone your trading strategy. For example, Bollinger Bands use standard deviation to measure how far a price is from the mean. Here, the further the standard deviation is from the mean, the more likely the price is to revert. Mean reversion is predicated on the idea that prices that reach an extreme will revert to their average. This strategy is best suited for traders who monitor for significant deviations from historical averages, anticipating a reversal to the norm. The Relative Strength Index is a momentum oscillator that measures the speed and change of price movements.

Mean Reversion Trading: Indicators and Trading Strategies

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.

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. There are notable exceptions where there were large price https://www.investorynews.com/ moves, and these also tended to reverse near similar levels on the PPO. 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.

what is mean reversion trading

Traders can select the tool, then select the first point in time and connect the tool to another point in time. To understand and calculate mean reversion, traders need to calculate the mean. Practically, you 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.

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

Time frames for mean reversion are dependent on the trader or investor’s objectives, risk tolerance, and the asset being traded. The theory of mean reversion is focused on the reversion of only relatively extreme changes, as normal growth or other fluctuations are an expected part of the paradigm. Calculating mean reversion involves a series of statistical and quantitative steps to measure how far an asset’s price has deviated from its historical mean. Another consideration is that mean reversion is more effective in range-bound markets and less so in trending markets. 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. When in a strong bull market, you obviously want to be looking for opportunities to go long, as that is where the easy money is.

what is mean reversion trading

You’ll want to pay close attention to these events because they often signal reversals. When the price acceleration fails back into the channel, it provides a good entry signal with a definable risk area just above or below the overthrow price area. With CFD trading, you predict price movements rather than own the shares yourself.

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This concept is rooted in the statistical phenomenon known as regression toward the mean. Mean reversion offers a structured and versatile approach to trading but comes with its own set of challenges, including sensitivity to market conditions and higher https://www.topforexnews.org/ transaction costs. Therefore, it is crucial for traders and investors to be aware of these factors and use robust risk management techniques. These are used to identify potential support and resistance levels where the price may revert to the mean.

Plus, while reversion to the mean is a regular occurrence, prices rarely stay close to the mean for long. HowToTrade.com helps traders of all levels learn how to trade the financial markets. 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. 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.

Once we’re in a trade we also need, we also need to know when to exit the market. This is where the 10-period simple moving average comes into play again. What we’re looking for is for the price to reverse back to the 10-period SMA strategy. The objective of trend-following is to capitalize on assets moving strongly in a particular direction.

Discover the range of markets and learn how they work – with IG Academy’s online course. Interested in learning how to use stop-loss orders to manage your exposure to risk? This is a risky play but we have the edge on our side to play this kind of trick. After all, trading is a risky game and everyone needs to decide for themselves how to manage risk. More often than not the price will overshoot to the upside and break above the 10-period SMA. Let’s examine some of the main factors why mean reversion trading works.

This creates the opportunity to profit if the pairs start to align again. It does not matter to a pairs trader which asset rises or falls; they are simply betting that the two prices will converge back to each other and start moving in alignment again. 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.