Mean Reversion Trading Strategies Backtest With Mean Reverting Indicators

what is mean reversion trading

This helps to control the loss in the event that the price continues higher instead of going back to the mean. When the prices deviate from one another; for example, coinmama exchange review one drops when the other doesn’t; this creates a potential mean reversion trade. To understand and calculate mean reversion, traders need to calculate the mean.

Consequently any person acting on it does so entirely at their own risk. 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 xm group broker 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. There are advantages and disadvantages with every trading strategy, and mean reversion is no exception. It’s up to the individual to assess their own skill level, investing goals and risk attitude to consider whether this popular approach is suitable.

what is mean reversion trading

Standard deviation is a statistical measurement that sheds light on historical volatility. By measuring how much the price deviates from its mean, this indicator can help traders understand the typical magnitude of price movements. And that’s the basic idea of using mean reversion strategies – looking for extreme changes in prices in an asset price with the assumption that prices tend to return to their average prices.

This normalization can be due to various factors, including changes in market sentiment, economic factors, or simply the random fluctuations that occur in markets. The act of buying and selling securities intra-day with the expectation of making fast profits within minutes to hours is known as day trading. As the asset approaches the mean, it’s your goal to determine the strength of the pullback and the broader context of the stock or stock market. Either way, these areas of resistance often provide very good risk to reward for short-sell trades. The objective of trend-following is to capitalize on assets moving strongly in a particular direction. The objective of mean reversion is to capitalize on price deviations from an established mean or average.

Day trading and mean reversion

The Z-score measures how many standard deviations an element is from the mean. 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. Although most people prefer the trend-following approach, I never felt comfortable with the general trend-trading mindset and I started looking at mean reversion trading very early on. In the following article, we take a look at mean reversion trading, what the most overlooked aspects are and which challenges a mean reversion trader has to deal with. Based on our backtesting result, on average your trades should reach the second target within 1-3 days.

In summary, the most alluring thing about mean reversion trading is the high win-loss ratio and the simplicity behind it. One thing to keep in mind is that the mean reversion strategy tends to perform poorly when the market is in a hard-mode trend. But that shouldn’t be much of a big deal since the market is ranging 75% of the time.

But you can’t deny that the system is robust enough to still have an edge when traded on different markets. So, you’ve seen the mean reversion strategy on the S&P 500 only get you 38 opportunities over the last 25 years. This means we’ll need to exit our trade on the next day (when the market opens). What we’re looking for is, for the 10-period RSI to cross above 40 which happens only after the market rallies higher.

what is mean reversion trading

Mean reversion is a theory in finance that suggests that an asset price will always return to its historic average over time. This means that an asset that spikes suddenly will pull back in order to retest its historic range over time. Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 69% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money. Because of these unknowns, most professional traders have strict risk-management​​ protocols.

Mean reversion in pairs trading

This concept is rooted in the statistical phenomenon known as regression toward the mean. Traders who use this strategy typically look for opportunities to buy or sell assets when prices deviate significantly from their historical mean in anticipation of their eventual return to it. In a healthy trend, you will likely see a stair-step upwards until the move reaches a climactic pitch, signaling the end of the trend. For this mean reversion trading strategy, the entry criteria are quite simple. Day traders often use short-term moving averages to identify the intraday mean price.

  1. Because of these unknowns, most professional traders have strict risk-management​​ protocols.
  2. Since it is possible that the two assets may not move in unison again, a stop-loss can be used to control the potential loss on each trade.
  3. You’ll also hear from our trading experts and your favorite TraderTV.Live personalities.
  4. Nonetheless, the technique works pretty much the same for any chosen timeframe.

While reporting services provide the averages, identifying the high and low prices for the study period is still necessary. Trading forex markets using mean reversion requires an account with a forex provider like IG. Many traders watch major forex pairs like EUR/USD, GBP/USD, or USD/JPY for mean reversion opportunities. You can help develop your forex trading strategies using resources like IG’s Trading Academy.

#3: Buy on the next day’s open

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. It doesn’t matter to the trader which asset falls or rises, as they seek to profit on the mean reversion.

A historical mean reversion model will not fully incorporate the actual behavior of a security’s price. For example, new information may become available that permanently affects the long-term valuation of an underlying stock. In the case of bankruptcy, it may cease to trade completely and never recover to its former historical average. On 28th October 2020, the S&P 500 is above the 200-day moving average—which means you can look for buying opportunities. The idea behind mean reversion trading is to identify stock markets in an uptrend, buy the pullback, and sell the rally.

Standard deviation, Bollinger Bands, and money flow are used to determine the distance away from the long-term average; therefore, these tools can be used to track unusual price movements. Applying that knowledge, investors are capable of measuring and determining when to buy under the mean and sell above it. Mean reversion is also used in options pricing to better determine how an asset’s fp markets review volatility fluctuates along with its long-term average. One possible explanation why stocks revert to mean could be margin, or rather the lack of margin. As stocks go up and down they become more liable to rebalancing, and this means selling those stocks which have risen and buying those which have fallen. At this point, you’ve learned a simple mean reversion trading strategy that works.

Now, let’s take a look at an example of how to trade financial assets using the mean reversion strategy. For this mean reversion trade example, we will use the intraday mean reversion strategy. The rationale behind the mean reversion theory is that over time, prices that are unusually high or low will tend to normalize to their average values.

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