What is Mean Reversion and How Does It Work? IG International

Pay close attention to the way in which GOOGL overthrows the upper bounds of the channel ever-so-often. If moving averages aren’t your thing, channels can be a great way to judge the support and resistance of any trend, vertical or horizontal. Not only can it help visualize where support is coming in at the lows, but also where resistance is being met at the highs.

  • While stocks can continue their upward or downward momentum much further than many traders would suspect, they can’t go up or down forever.
  • If there is a downtrend, prices tend to fall before reverting to an average – when they do revert to an average, this tends to be a good opportunity to short or sell.
  • Mean reversion happens because the prices have a tendency to overshoot and undershoot their intrinsic value.
  • To get a reliable level, you need to experiment with different moving averages and try out different levels.
  • When in a strong bull market, you obviously want to be looking for opportunities to go long, as that is where the easy money is.

One step further, you can make use of Moving Average Convergence Divergence (MACD), a technical indicator of momentum that uses moving averages to establish a trend’s strength. 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. 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.

Complementary Technical Indicators and Financial Information

Once you’ve drawn your line, clone the line on the other side of the developing channel. The more channels you study, the better you’ll get at harmonic trading patterns judging the support and resistance sooner in the trend. In this example, we have the 20ema in blue, the 50sma in red, and the 200sma in black.

One thing you should notice in the image above, however, is that eventually, the stock becomes EXTREMELY oversold. Notice how it breaks the lows of the channels also, entering a free-fall. This is another opportunity to capitalize on a mean reversion trade called a parabolic reversal strategy. If you want to learn more, then check out The Pullback Stock Trading System—a mean reversion trading strategy that has generated 1451% since 2000. As you can see, this mean reversion trading strategy is “interesting”. Let’s have a look at a few examples so you can see how this mean reversion trading strategy works.

Understanding Mean Reversion

Moreover, Fibonacci retracements are used to identify potential levels where the price may revert to the mean. Some considerations involved in mean reversion involve time horizon and market conditions. The effectiveness of a mean reversion strategy can vary based on the time horizon.

For starters, supporters of the efficient market hypothesis find the entire premise of mean reversion unsustainable. According to this hypothesis, the market reflects all available information at all times – prices are always rational, so a sudden increase or decrease has to be due to some specific reason. If that is indeed the case, there is no guarantee that a price correction to the previous mean is going to occur. Still, in order to fully understand a thing, one has to consider its faults, potential shortfalls, and take a look at opposing viewpoints. And just like almost everything in finance is a point of contention, so too is mean reversion – it isn’t without its detractors.

Linear regression is a directional mean reversion strategy that is among the easier ones to execute. The strategy functions by plotting a linear regression line – which is basically a sideways line that shows us the price action which took place during a specific time period. The chief advantage of Bollinger bands is that they are quite flexible – as far as time frames go, they can be used to determine price action through an hourly, daily, weekly, and even monthly lens. Relationship mean reversion is an approach that seeks to profit off of the relationship between two securities. In summary, the most alluring thing about mean reversion trading is the high win-loss ratio and the simplicity behind it.

What is the Mean Reversion Trading Strategy?

Get a deeper understanding of the financial markets – and develop your trading skills – with interactive online courses, webinars and seminars from IG Academy. As you study your mean reversion strategy, be sure to take simulated trades and then qualify your stats in our analytics page that is built-in. The more success you have, the more confidence you’ll have in trading the mean reversion strategy in a real market environment. As the trend accelerates, you notice that the stock becomes extended from the 9-ema on a 1-minute chart.

Learn to trade

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 how to buy bondly a big deal since the market is ranging 75% of the time. A lot of the times when you’re doing mean reversion trading, you’ll be quick in-and-out of a trade.

Using a simple AVERAGE() function in a spreadsheet setting like Microsoft Excel’s can determine the mean price for a given market. Traders looking for long-term extremes might factor years’ worth of data into the calculation, while those looking for shorter-term strategies might simply look at the last few weeks. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite.

Finding targets for mean regression trades

These indicators are used to measure whether prices are overextended to the upside or the downside. When prices are overextended, it can be a signal to fade the move and enter into a mean reversion trade. The theory is that prices tend to move back towards their average price over time. This type of trading looks for opportunities to buy when prices are below the average and sell when prices are above the average, and is often considered a contrarian investment strategy. 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.

The idea behind mean reversion trading is to identify stock markets in an uptrend, buy the pullback, and sell the rally. Now, this trading strategy can be applied to other markets but for this post, I’ll focus only on the stock market. Mean reversion trading is a strategy that buys when an asset price is low, and then sell it on the next “bounce” higher.

This approach can be applied across various financial instruments, including stocks, commodities, and currencies. A more scientific approach might include incorporating the Standard Deviation indicator into investor vs trader a platform that can more dynamically adjust to periods of varying volatility. The mean reversion trade for down trending stocks really looks no different, just a mirror image of an up trending stock.