Mean reversion strategies
As you might already know, there are many different approaches to trading the financial markets. Regardless of whether you are trading stocks or forex or futures, when your trading is based on technical analysis, chances are that there is more than one way to approach the markets.
Some of the common examples in technical analysis includes price action based methods, wave counting such as using Elliott waves or harmonic patterns and also indicator based strategies. Each of these approaches to the markets are very unique.
Another approach to the markets is known as the mean reversion strategy.
In a mean reversion strategy, the concept is very simple. A trader simply anticipates that will revert to its mean or the average price.
Talking about average or mean prices, chances are that you might have used technical analysis based indicators such as moving averages. A mean reversion strategy basically builds upon the moving average.
Just like there are many different types of technical trading strategies, mean reversion strategies are also of different kinds. From using regular bands to building complex trading indicators, traders have come up with many different forms of technical trading methods.
In order to understand how mean reversion strategy works, we first need to look at what a mean reversion is all about. However, traders need to bear in mind that as with any technical trading strategy mean reversion strategy also has its own pros and cons.
Therefore, as a trader you need to fully understand the advantages and disadvantages of trading with a mean reversion based technical strategy. This approach of trading the markets is also constantly featured among really Is academic journals.
Not all markets behave the same way. In order to become truly successful in trading with mean reversion strategies, traders need to be very familiar with the market that they are trading. One of the common features that you will find about mean reversion strategies is that most of the chart illustrations and trading setups are often depicted in hindsight. This lures the trader into believing that mean reversion strategies work.
The reality is that there is no hard evidence that can point to the fact that mean reversion strategy is have an edge over other technical Analysis based trading strategies. In this article, we firstly explore what mean reversion is all about and also point you to some commonly used mean reversion base trading strategies.
What is mean reversion?
Mean reversion, also known as regression to the mean is a technical term that is used to describe when a variable moves to the extreme. Various scientific studies have proven that when a variable is at its extreme value, that variable has a tendency to move back towards its mean price. Mean reversion is primarily used with statistics. This concept was first popularized by Sir Francis Galton in the 19th century. Various scientific studies have shown that reversion to the mean is a concept that is basically difficult for the human mind to grasp or understand.
This is partly due to the fact that the human mind is biased towards recognizing patterns and casual explanations. The scientific studies have shown that reversion to the mean can have huge consequences if they are misinterpreted.
Therefore, from a trading perspective we can conclude that if a trader does not understand how mean reversion works there is a big chance that they could end up facing huge losses on their trades. Therefore, it is not surprising to see that mean reversion based strategies are not that popular.
Why it is easy to plot a mean reversion trade in hindsight it can become next to impossible or difficult at the very least to spot a potentially profitable mean reversion trade. Another factor to bed in mind is that mean reversion based technical analysis is predictive in nature.
Because the financial markets do not move in an orderly fashion, the randomness that is evident in the financial markets can create havoc with your analysis. Still, you will find quite a few mean reversion based trading strategies.
Some common examples include using mean reversion in fundamental analysis of stocks. In such an approach, investors basically try to seek out stocks that are trading at a premium order discount. The basic concept of valuation comes into play here and investors try to grab stocks that trading at a discount. This concept basically revolves around mean reversion.
While this may be true for stocks that are trading at a discount or at a premium, studies have shown the price of some stocks tend to remain at the extreme levels. This can make it difficult for speculating on the prices in the very short term.
As you can see from the above,
while one can expect the price of a stock to revert to its mean, there is no accurate way of saying when the reversion to the mean will occur.
A good example of this can be seen from the .com bubble. Just before the bubble burst many technology-based stocks were seen training at extreme valuations. This occurred over the years leading into the .com bubble.
While it was evident that the stocks in would return to the mean, it was difficult to predict when this would happen.
Mean reversion in forex trading
Applying the concept of mean reversion in Forex trading requires a slightly different approach. This is because forex trading is quite different compared to stock trading. It is very rare that you will see traders investing in the currency markets over long period of time. Therefore, trying to predict price based on mean reversion can be risky. Many traders tend to use the moving average as a way to understand the mean or the average price. The mistake here is that traders use the average price over a particular period of time as the mean price.
This is not entirely true. The true mean price of the currency pair is based on fundamental indicators. The fundamental indicators such as GDP growth, inflation and unemployment along with the central bank interest rates account for the true valuation of the currency pair.
Having outlined the risks of trading with the mean reversion strategy, let us now take a look at a few examples of how the strategies are used in trading the currency markets.
Mean reversion trading strategies in forex
We can start with the simple mean reversion based trading strategy where we make use of Bollinger bands. Traders would know that Bollinger bands are a form of volatility bands. Bollinger bands are built up on a moving average with the outer bands also known as the upper and lower Bollinger bands displaced by a certain amount of standard deviation.
When these bands expand and contract, they depict the rising and falling volatility of the price. Using Bollinger bands one can develop a mean reversion trading strategy. The concept here is to buy when price is at the lower Bollinger band.
Likewise, traders can sell when price is at the upper Bollinger band. The mean price is of course the middle Bollinger band.
The chart below gives an example of Bollinger band. Here we make use of 200 period setting with the regular standard deviation left unchanged. We observe of the daily chart timeframe.
Mean reversion using Bollinger bands
In the above chart you can see the highlighted areas. These points depict the reversion to the mean. The mean here is nothing but the 200 day moving average. As and when price moves to one of the extreme bands, you can either go long or go short, targeting the 200 day moving average.
While this is a very basic strategy, it can be enhanced by making use of oscillators to determine overboard and almost all conditions in the market.
Another example of using the mean reversion strategy includes making use of the double or even triple Bollinger bands. In this reversion to the mean trading strategy, traders make use of two or three Bollinger bands.
Why is the look-back period for all the Bollinger bands remain the same, each of the Bollinger bands are set to different levels of standard deviation.
The next chart below shows one such example.
Double Bollinger band mean reversion trading strategy
In the above chart, we use of 20 period Bollinger band. The first Bollinger band is set for two standard deviations, and the second Bollinger band is set for three standard deviations. When we combine the two Bollinger bands, what do you basically get is two levels of volatility.
When price stretches to one of the extreme levels, such as the outer Bollinger band which has three standard deviation setting, it can signal a reversion to the mean in price. If you carefully look at the above chart, you will find two areas that we have marked with arrows.
Then price touches the outer-extreme Bollinger band (set at three standard deviations), a long or short position can be taken. This can happen when the next candlestick draws close to the outer band but does not touch it.
When you see such a scenario being set up in the markets, you can prepare to go long or short. The target or the take profit level is of course the middle Bollinger band. An interesting observation to make here is that using this reversion to the mean strategy, we are not focusing on the trend.
Rather, traders make money by buying or selling when price is at an extreme value. This alternate option of trading the markets can be further enhanced by using various filters such as reversal candlestick patterns.
Furthermore, mean reversion based technical trading strategies can be developed using volatility bands, standard deviation bands, price channels etc. You can also apply price action based channels such as the equidistant channel, Fibonacci channel in the application of mean reversion trading strategies.
Mean reversion based trading strategies – conclusion
In conclusion, mean reversion is a concept that is primarily used in statistics. This is a field of study where a variable is set to revert to its mean value over a period of time. In the financial markets are just forex, traders use this very concept in applying it to the price of the security.
Whenever price deviates too far away from its mean price traders can take advantage of this phenomena and find trading opportunities.
While mean reversion might sound simple in theory, traders need to have adequate practice before they can really make money using this approach.
As we have outlined earlier in this article, mean reversion is predictive in nature. This brings the risk that price can remain at its extreme value for prolonged periods of time. As a result, the chance of a trade going bad is quite high.
Because the markets are random there are many examples where price of a security continues to remain at one of the extreme levels. Being caught up in such trades can be very disastrous to your trading.
Still, quite a few traders prefer to use this approach to speculate in the markets. We have outlined two very simple trading strategies that are based on the concept of reversion to the mean. While the trading strategies might look very simple in nature, they can be converted into are mechanical grading system which can be further automated and back tested to truly find if they are effective.
Remember that different markets behave differently. For example, the volatility that you find in the EURUSD currency pair is very different when you compare it to the volatility of the USDJPY currency pair. Likewise, when you look at the commodity markets such as gold, silver, or oil, the volatility here can be very different.
Traders should not make the mistake of using the same strategy across the different markets when it comes to applying the concept of mean reversion.
Therefore we highly recommend that mean reversion trading strategies should be applied only when you are already familiar with the behavior of the securities or the currency pairs that you’ll want to trade.