The article on Mean Reversion Trading is the opinion of Optimus Futures, LLC.
- Asset prices often tend to revert back to an established mean after an extreme move.
- Successful application of this principle in trading requires patience and skill.
- Continuous adaptation is critical when trying to fade markets.
It doesn’t guarantee a snap-back in price; sometimes the model will just break and prices will run. But when it does work out, the rubberband makes for a good metaphor for this model. Enter Mean Reversion Trading.
Just as the name suggests, mean reversion trading revolves around the idea that asset prices have an average or “mean” level to which they tend to return.
Another metaphor to help you understand this concept is the pendulum. It swings to the left, then the right, but always seems to find its way back to the center.
You’re probably wondering: “Is it really that simple? Can I just wait for an asset to swing away from its mean and bet that it’ll swing back?” Well, yes and no.
While the concept itself is straightforward, applying it effectively in the market requires a keen eye, discipline, and a nuanced skills to manage the trade, especially if it doesn’t work out.
So, let’s dive deeper and explore this method of trading. By the end of this article, you’ll have the basics down and maybe even develop a few strategies along the way. Let’s start from the beginning.
What is Mean Reversion Trading?
Mean Reversion Trading is a trading strategy based on the assumption that assets tend to gravitate toward their historical average values over time.
When prices deviate significantly from its average or ‘mean’ price, it tends to to revert to its historical norm.
Traders take advantage of this—either buying or selling—to catch the move back towards its average value.
Why Does Mean Reversion Trading Deserve Your Attention?
There’s an age-old adage in the trading world: “Markets ascend the stairs but plummet down the elevator.”
This essentially captures the swift pace at which prices can drop compared to their gradual rise. And for those intrigued by mean reversion trading, this dynamic is pure gold, presenting lucrative trading windows.
Trend-following might be all the rage, but it’s not everyone’s cup of tea.
It’s crucial for traders to resonate with a strategy that aligns with their personal temperament and cognitive style.
For those who get antsy during the snail-paced climbs of trending markets, the brisk nature of reversal trading could be a refreshing change.
That said, mean reversion isn’t for the faint-hearted.
If market volatility sends your heart racing or if you’re prone to making spur-of-the-moment trade decisions, this method might prove challenging.
Reversals can be unpredictable, marked by significant momentum and volatility. So, as with all things in trading, know your limits before diving in.
What Are the Theoretical Assumptions Behind Mean Reversion Trading?
The main assumptions are as follows:
- Law of Averages and statistical principles: The law of averages suggests that outcomes will eventually balance out to reach a “normal” state, or, better yet, an average. In trading, if prices move significantly from its average price, it will inevitably revert to that average over time.
- Market equilibrium: If you know anything about economics, you’ll understand that financial markets always reach a temporary state of equilibrium. When does this happen? It’s when buyers and sellers agree on the price of a given asset; when price is not too expensive and not too cheap.
- Historical vs. statistical mean reversion: Historical mean reversion considers past price behavior of an asset to determine its mean, while statistical mean reversion uses mathematical models and standard deviations to identify potential mean reversion points.
What Are the Key Characteristics of Mean Reversion?
Before jumping into the market for a quick top or bottom fade, here are three characteristics you should consider.
1 – Overbought and oversold conditions: Are you certain that an asset has entered overbought or oversold territory? If so, what methods are you using to confirm that assessment?
2 – Role of volatility: How volatile was the move toward the extreme end of that overbought or oversold level? If volatility didn’t play a role, then you run the risk that price can jump against your position. And that could lead to a whopping loss.
3 – Understanding the phase of reversion: Are you trading a trend reversal, a reversion in a wide trading range (sideways market), or a correction within a larger trend? You should have a good sense as to where and when prices might reverse against your direction in case you need to manage your trade or make a quick exit.
So, what tools might help you fade the market a bit more effectively? Here are a few to consider.
Indicators and Strategies for Mean Reversion Trading
Moving Average Convergence Divergence (MACD): The MACD can help you spot divergences, but it also has a lot of false signals.
To avoid this, pay attention to the larger price context, and enter a trade only upon confirmation, which often means a pattern breakout or a breakout from either support or resistance.
In the example above we saw divergence between the MACD form over several candles.
Still, this isn’t enough to signal a short trade, as the MACD is notorious for given false divergence signals.
So, what we do is wait for confirmation. Once price broke below the most recent swing low, it was a signal to go short the market.
Some traders thought that the swing low would have served as support, but that’s where the MACD divergence came into play.
It signaled that price was about to move lower (not necessarily to the average, but more a trend reversal). As far as averages are concerned, the next indicator was designed to do just that.
Bollinger Bands: These consist of a middle band and two outer bands typically set to 2 standard deviations.
Prices that touch or move outside these bands might indicate overbought or oversold conditions, respectively, and they tend to bounce back toward the middle band representing the average. Let’s take a look.
The example above shows exactly what Bollinger Bands are designed to indicate. Here, prices spiked upward with multiple closes above the upper band.
Considering that the upper band represents two standard deviations. The chances of a correction are high. But how deep might the correction go is something that we couldn’t predict.
A good trade setup would have been on the down candle after the highest swing point.
A short entry upon the breakout of that candle with a stop loss above the highest high would have been the smartest way to fade this market. As you can see, prices eventually reverted back to the moving average the following candle.
Relative Strength Index (RSI): This momentum oscillator measures the speed and change of price movements.
An RSI above 70 suggests overbought conditions, while below 30 indicates oversold conditions. Take a look the chart below.
The oversold reading in the RSI made for a perfect entry point to catch the rally.
You’ll notice that the buy signal was a breakout of the smaller congestion area following the drop. A stop loss would have been placed below the lowest swing low point.
Stochastic Oscillator: This metric compares a particular closing price of an asset to a range of its prices over a certain period. Like the RSI, it can help identify overbought and oversold conditions.
The example below shows a quick scalp using stochastics.
Prices were hovering in overbought territory as it continued to rally for several candles.
What drew a trend line and waited for prices to fall below it. Fortunately, the trendline break coincided with a decline in the stochastic reading as well.
After entering a short trade, we would have exited that position once price bounced back after entering oversold territory.
Pinpointing vs Approximating Tops and Bottoms
One of the biggest challenges many newbie traders face when dabbling in mean reversion trading is the urge to pinpoint the exact moment a trend will reverse.
It’s like trying to predict the precise moment when a pendulum will swing back. This doesn’t work, at least not consistently enough for you to continue attempting it.
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.
Hunting for the utmost peaks and valleys is NOT the name of the game in mean reversion.
It’s fraught with risks and can lead to missteps. Instead of trying to nab the highest highs or the lowest lows, a wise trader observes, waits, and jumps in only when the tide has undeniably turned.
Think of it this way: be a follower of reversals, much like trend-followers track trends.
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.
Same thing goes with mean reversion. All of the examples above demonstrate this approach of waiting for confirmation and not just blindly jumping in.
Don’t Forget to Manage Your Risks
Risk management is essential because no strategy guarantees success every time. By properly managing risk, you can withstand losses and still remain in the game.
One way to manage risk in this arena is to identify false reversions. False reversions occur when a price seems to be reverting to its mean but then continues its trend. It is important to recognize and avoid these false signals to avoid losses. When you can’t, however, that’s what your stop loss is for.
Another way to manage risk is to size your positions appropriately. Never overexpose your capital by investing too much in a single trade. Don’t bet the farm on a trade, so to speak.
Figure out the right amount to risk and don’t commit anything more than that.
Finally, it is important to set stop-loss orders and profit targets. This is self-explanatory, and we’re certain you know it.
It’s not discussed much but another risk factor is, believe it or not, yourself, as in your frame of mind and trading psychology. Let’s tackle this next.
Psychological Challenges and Biases
Don’t let a few wins go to your head. Just because you hit a couple of home runs doesn’t mean you’re invincible. Keep your feet on the ground and stay true to your game plan.
When it comes to playing the waiting game, think of it as fishing. The big catch might not bite right away.
Give it some time; patience can be your best buddy in this. You can’t force a trade. You have to wait. Might as well develop patience, right?
Beware cognitive biases. If you don’t know what those are, then look it up.
Traders often fall prey to biases like confirmation bias, where they seek information that aligns with their beliefs and ignore contradictory data.
There’s plenty more too, so educate yourself with regard to this challenge.
The Bottom Line
Mean Reversion Trading is all about riding the correction up or down from an extreme price move. To do it well, you have to really know your stuff.
You need the right skills and the right mindset to allow such a strategy to work.
So, always be on your toes, learn from each trade, and be ready to change up your game if needed. Happy trading!
Trading in futures involves a significant risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.
