This can be done using MACD or the similar Percentage Price Oscillator (PPO) strategy – a technical momentum indicator that shows the relationship between two moving averages in percentage terms. Most traders use a stop-loss to limit potential losses for occasions when the strategy fails. A trader looking to profit from the divergence could buy the underperforming forex pair, while simultaneously shorting the stronger pair.
- We have no knowledge of the level of money you are trading with or the level of risk you are taking with each trade.
- Ultimately, the choice of which type of moving average to use will depend on a trader’s personal preference and trading style.
- Plus, while reversion to the mean is a regular occurrence, prices rarely stay close to the mean for long.
- Conversely, if the stock drops to $20, the trader might buy it, anticipating a rise back to the $50 level.
- The difference between the intraday mean reversion strategy and longer-term strategies is seen in the period of the moving averages used and the selected timeframe.
This strategy includes the risk of the market producing large short-term losses or potentially never coming back to its mean if a large economic shift occurs. Mean reversion can apply to a multitude of assets and strategies, and many traders consider it to be one of the strongest mathematical forces in the market. For more complex algorithmic trading strategies using mean reversion, we also offer trading on the MetaTrader 4 platform (MT4).
An oversold market is when the current price of an asset is significantly lower than its average price, while an overbought market when the current price is significantly higher than the average price. There are many methods traders use to identify oversold and overbought market situations and also estimate the mean value. We’ll discuss all those later under the mean reversion trading strategies.
When a stock goes parabolic, it often becomes the target of many traders looking to take advantage of the mean reversion trade. While stocks can continue their upward or downward momentum much further than many traders would suspect, they can’t go up or down forever. As you can see, this mean reversion trading strategy is “interesting”.
Standard Deviation
You must review and agree to our Disclaimers and Terms and Conditions before using this site. One of them is that the market can continue moving in one direction without letting up. Check out TrendSpider’s Strategy Tester to experiment with hundreds of possible trading strategies without taking any risk. Explore the range of markets you can trade – and learn how they work – with IG Academy’s free ’introducing the financial markets’ course.
Mean Reversion Trading Strategies Explained
Finally, swing traders also can use candlestick patterns like the doji, hammer, bullish engulfing, and bearish engulfing patterns to identify potential reversals, including mean reversion opportunities. Meanwhile, the mean price of the stock lies somewhere between the two extremes. So, at that significantly lower price, traders and value investors would consider the stock underpriced (undervalued). Expectedly, they start buying the stock again, increasing the demand for the stock.
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. A regression is simply another way of measuring what normal looks like. The chart above shows that the price tends to return to “normal” levels, which in this case is the regression line.
For example, if an M&A deal occurs in a company, the company being acquired will often have a bullish breakout and not return to the range again. This happens because the stock will often jump to match the acquisition price. However, faith in a mean-reverting system can quickly grind to a halt when you get the infrequent big loser.
How does the mean reversion trading strategy work?
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. While reversion to the mean occurs regularly, prices rarely stay exactly at the mean for long. Mean reversion in practice demands a harmonious combination of meticulous analysis, insight, and precise timing.
With that said, we will be using the 50 EMA and the RSI on the hourly time frame in this example. Stay on top of upcoming market-moving events with our customisable economic https://broker-review.org/ calendar. Discover the range of markets and learn how they work – with IG Academy’s online course. Consider a mean reversion situation involving the stock of Company XYZ.
Would you like to receive Trading Edges monthly?
Mean-reversion trading is a strategy to take advantage of the natural swing pattern of the market. It is based on the idea that the price often reverts to its mean after making an exaggerated move to one side. When a stock’s price is rising, it attracts many investors and traders who rush to buy the stock in order not to miss out on the opportunity — fear of missing out (greed). As a result, there will be a higher demand for the stock than supply, making the price rise more and more. The mean-reversion theory is based on the statistical concept of central tendency, which shows that for any variable, the majority of the data set revolves around the center and only a few outliers.
How much does trading cost?
The mean reversion trading systems are more appealing to a lot of traders because it tends to have a higher win rate as opposed to the trend following strategies. Even when the markets are in well-established trends, mean reversion happens quite often. Mean reversion is a flexible strategy, capable of being applied to a vast spectrum of asset classes such as stocks, commodities, and forex. However, its efficacy can differ, and it’s crucial for traders to evaluate its compatibility, taking into account the distinct traits and liquidity of each asset class.
Because of these unknowns, most professional traders have strict risk-management protocols. They can define an exit point where their position will close out if the price doesn’t move in their expected direction, helping to minimise losses as much as possible. For example, to carry out a pairs trade, select one of the instruments from the pair that you are interested in. plus500 review Select this product from the Product Library to open a trading chart. Next, in the Product Library, search for the other asset in the pair that you want to trade. On the chart below, we have dragged West Texas Crude Oil on to the existing Brent Crude Oil chart to compare the two types of oil and look for potential divergence and a possible reversion to the mean trade.
Calculating mean reversion using a chart
This article gives you some input and advice on how to develop a mean reversion trading strategy and discusses its pros and cons. There is no better way to practice the mean reversion trading strategy than in a simulator. Here at TradingSim, we offer an app that allows you to practice mean reversion trades with over three years of historical market data.
