Mean Reversion Trading Strategies
Mean reversion is a concept used by traders looking to profit from market movements that deviate from their long-term average. These strategies involve identifying situations where an asset’s price or some other metric has moved too far away from its historical mean and taking positions that anticipate a reversal of the trend.
In this article, we’ll explore the basics of mean reversion trading, including how it works, common strategies used by traders, and the advantages and drawbacks of this approach. Whether you’re a novice or experienced trader, understanding mean reversion strategies can help you navigate the markets with greater confidence and potentially improve your returns.
What Is Mean Reversion?
Mean reversion is a theory based on the belief that prices and other metrics tend to fluctuate around their long-term mean or average value. In other words, mean reversion assumes that when a price or other metric moves too far away from its historical average, it is likely to revert back towards that average over time.
In trading, mean reversion can be applied to a variety of market metrics, including price, volatility, and other indicators. For example, in the case of price, mean reversion traders might look for stocks or other assets that have experienced a sharp price increase or decrease, indicating that the market may have overreacted to some news or event. They may then look to buy or sell those assets in anticipation of a reversion to their long-term average price.
Similarly, mean reversion can be applied to volatility, where traders might look for periods of unusually high or low volatility and use that information to inform their trading decisions. Other indicators, such as moving averages, can also be used in mean reversion strategies to identify overbought or oversold conditions in the market.
Mean Reversion Trading Strategies
Here are some common mean reversion trading strategies:
Moving Average Mean Reversion Strategy
In this strategy, traders look for price divergences from the moving average, which can signal potential buy or sell opportunities. When the price of an asset is trading below its moving average, it is considered undervalued, and traders may consider buying the asset as it is likely to revert back to its mean. Similarly, when the price of an asset is trading above its moving average, it is considered overvalued, and traders may consider selling the asset as it is likely to revert back to its mean.
The moving average used in the moving average mean reversion strategy is typically a simple moving average (SMA), which calculates the average price of an asset over a set period of time (e.g. 50 days, 200 days, etc.) by summing up the prices and dividing by the number of periods. However, some traders may use other types of moving averages, such as the exponential moving average (EMA), which gives more weight to recent price data and may respond more quickly to price changes. There are several other moving averages that traders can use. Ultimately, the choice of which type of moving average to use will depend on a trader’s personal preference and trading style.
Pairs Mean Reversion Strategy
In this strategy, traders start by identifying two related instruments that have historically moved together, such as two stocks in the same industry or two currencies in the same region. They then calculate the historical relationship between the two instruments, such as by calculating the spread between their prices. The spread represents the difference in price between the two instruments and can be calculated by subtracting one instrument’s price from the other.
When the spread deviates from its historical mean or average, traders may consider entering a trade. For example, if the spread widens beyond its historical range, traders may consider buying the instrument that is relatively cheaper and selling the instrument that is relatively more expensive, with the expectation that the spread will eventually revert back to its mean. Conversely, if the spread narrows beyond its historical range, traders may consider selling the relatively cheaper instrument and buying the relatively more expensive instrument, with the expectation that the spread will eventually widen back to its mean.
Volatility Mean Reversion Strategy
In this strategy, traders typically use a volatility indicator, such as the VIX (CBOE Volatility Index), to identify periods of high or low volatility. The VIX is an index that measures the implied volatility of options on the S&P 500 index and is often used as a gauge of market fear or uncertainty.
When the VIX is trading above its long-term average or mean, traders may consider selling options or shorting the underlying asset, with the expectation that volatility will eventually revert back to its mean. Conversely, when the VIX is trading below its long-term average, traders may consider buying options or going long on the underlying asset, with the expectation that volatility will eventually increase back to its mean.
Traders may also use other volatility indicators, such as historical volatility or implied volatility of individual stocks or other financial instruments, to identify potential mean reversion opportunities.
There are several other indicators that traders use to identify potential mean reversion opportunities in the market. Here are some examples:
- Bollinger Bands: This is a technical analysis tool that consists of a moving average and two standard deviations plotted above and below the moving average. The upper and lower bands serve as resistance and support levels, and when the price of an asset moves outside of the bands, it is considered overbought or oversold.
- Relative Strength Index (RSI): The RSI is a momentum oscillator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. When the RSI reaches a certain level, such as 70 or 30, it is considered overbought or oversold.
- Stochastic Oscillator: This is a momentum indicator that compares the closing price of an asset to its price range over a specified period. It helps identify overbought and oversold conditions in the market.
- Moving Average Convergence Divergence (MACD): The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of an asset’s price. It helps traders identify potential trend changes and momentum shifts in the market.
It’s worth noting that no indicator is perfect, and traders should use multiple indicators to confirm their analysis and make informed trading decisions.
Pros and Cons of Mean Reversion Trading Strategies
Here are some pros and cons of mean reversion trading strategies:
- Simple to understand and implement: Mean reversion trading strategies are relatively simple to understand and implement, making them accessible to traders of all levels of experience.
- Historical evidence: Mean reversion trading strategies have been successful in the past, and there is a lot of historical evidence to support them.
- Well-defined entry and exit points: Mean reversion trading strategies have well-defined entry and exit points, making it easier for traders to manage their risk and take profits.
- Market inefficiencies: Mean reversion trading strategies take advantage of market inefficiencies, which can provide an opportunity for profitable trades.
- No guarantee: While mean reversion trading strategies have been successful in the past, there is no guarantee that they will be successful in the future.
- Risk of prolonged deviation from mean: Although mean reversion trading strategies assume that prices and other metrics will eventually return to their long-term average, there is a risk that they may continue to deviate from the mean for prolonged periods, leading to potential losses for traders using this strategy.
- Difficult to identify the mean: Identifying the long-term average or mean can be difficult, as different methods can produce different results, and the mean can change over time.
- Requires discipline and patience: Mean reversion trading strategies require discipline and patience to wait for the price or other metric to move back towards the mean, which can be challenging for some traders who prefer more active trading approaches.
In summary, mean reversion trading strategies can be effective in certain market conditions and are relatively simple to understand and implement. However, they also come with their own set of risks and limitations. Traders should carefully consider their risk tolerance and investment goals before deciding to use a mean reversion strategy.
Example strategies based on Mean Reversion
The Bottom Line
In conclusion, mean reversion trading strategies can be a powerful tool for traders looking to profit from the tendency of prices and other metrics to return to their mean over time. By identifying situations where metrics have diverged significantly from their historical averages, mean reversion traders can enter positions with the expectation that they will eventually revert back to the mean.
Overall, mean reversion trading strategies can be a valuable addition to a trader’s toolbox, but they should be used in conjunction with other trading strategies and with a thorough understanding of the risks involved. By carefully managing risk and executing trades with discipline and patience, traders can increase their chances of success with mean reversion trading strategies.