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Mean Reversion: Trading Strategies & Indicators

Today, mean reversion trading remains a cornerstone concept among trading strategies. Some commonly traded assets well-suited for mean reversion strategies include stocks, forex, commodities, exchange-traded funds (ETFs), and fixed income instruments. The Z-score measures how many standard deviations an element is from the mean. When price approaches these levels, it can be a signal to fade the move. This approach works well when securities are trading within a range and each move towards an extreme is faded. Mean-reversion trading is a strategy to take advantage of the natural swing pattern of the market.

However, it is commonly applied to shorter timeframes such as daily or hourly charts. This is because mean reversion seeks to exploit short-term fluctuations in price, and these periods are long enough to establish a reliable mean but short enough to allow for frequent trading opportunities. Furthermore, upon using the mean reversion strategy, it is advisable to utilize multiple timeframe analyses. Standard deviation is a statistical measurement that sheds light on historical volatility.

  1. This means that when one asset in the pair deviates from the other – either rising or falling out of step – you can look to profit from the likely mean reversion.
  2. As a result, there will be a higher demand for the stock than supply, making the price rise more and more.
  3. For example, Bollinger Bands use standard deviation to measure how far a price is from the mean.
  4. See our Terms of Service and Customer Contract and Market Data Disclaimers for additional disclaimers.

An RSI above 70 suggests overbought conditions, while below 30 indicates oversold conditions. For those who get antsy during the snail-paced climbs of trending markets, the brisk nature of reversal trading could be a refreshing change. It’s crucial for traders to resonate with a strategy that aligns with their personal temperament and cognitive style.

Overview and Examples of Mean Reversion Strategies

The ranging period starting from August through November has generated 4 sell signals and 3 buy signals, which all eventually reached their target. A lot of the times when you’re doing mean reversion trading, you’ll be quick in-and-out of a trade. In this guide, you’ll learn a mean reversion trading strategy with some trading secrets that will assist you to limit the downside. The first part of the guide will highlight what is mean reversion trading, while in the second part we’ll reveal the mean reversion strategy and how you can fine-tune it to fit your personality. 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.

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Therefore, after drawing a regression channel, you can buy when the price moves to the lower side and exit when it moves to the middle line. The Relative Strength Index (RSI) and the Stochastic Oscillators are used to find overbought and oversold levels in the market. The theory is that an asset that reaches these extreme levels will often move back to the normal price. A regression is simply another way of measuring what normal looks like.

Then, using trade management techniques, you could have held for higher prices by putting a stop below the candle that broke vwap. As the price moves higher, you simply move your stop to below each candle producing a new high. Let’s take the Google chart that we used above, but repurpose it with channels instead of moving averages, this time. Pay close attention to the way in which GOOGL overthrows the upper bounds of the channel ever-so-often.

How to create a mean reversion trading strategy?

A notable example of such fluctuations is when the S&P lost the most it has since March 2023, exemplifying the importance of vigilance and strategic response in trading. Discover how to gci broker increase your chances of trading success, with data gleaned from over 100,00 IG accounts. Fortunately, the trendline break coincided with a decline in the stochastic reading as well.

It depends – you can’t expect to make money with a universal strategy. Mean reversion works excellent for stocks but not for commodities where trend following works much better. Because mean reversion has worked so well in the stock market for over two decades, most indicators that buy on weakness and sell on strength have worked. In almost all backtests, you will notice that stop-loss doesn’t work in mean-reverting strategies. Thus, stop-losses might be very detrimental to a strategy unless you set a very wide stop-loss. But if you have a very wide stop-loss, then you, in reality, don’t have a stop-loss.

What is Mean Reversion Trading?

This is because when two highly correlated pairs move out of standard synchronicity, history suggests they will eventually regress to the mean. Savvy mean reversion traders know better than to play this prediction game. Instead, they’re on the lookout for signals that a trend is genuinely losing its pep, indicating an imminent shift.

Because changes in the magnitude of price moves occur, a stop-loss order​​ helps to control losses when the price doesn’t do what history indicates that it might. 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. 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.

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With CFD trading, you predict price movements rather than own the shares yourself. This process is leveraged, so you could gain or lose money quickly – including the potential to lose more than your deposit. It’s a good idea to keep in mind that when you’re making your predictions, past performance isn’t a guarantee of future patterns.

In essence, it suggests that severe deviations from the mean are not sustainable long-term, and prices are apt to return to their average values eventually. Mean reversion is a key concept in trading theory which posits that prices tend to return to average levels, as extreme price moves – both up and down – are hard to sustain for extended periods of time. One of the best ways to find a target for 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.