Mean Reversion Trading: A Profitable Strategy for Short-Term Price Movements

Mean reversion is an interesting concept when it comes to trading in the financial markets,  when prices move away from an average price, they often tend to return toward that average soon after.  This is a move against the underlying trend.

When you spot a large move in one direction and if you’ve designed a mean reversion strategy, you can use this knowledge to help guide your trading as you expect a reversal to set up.

PRICE SURROUNDING AN AVERAGE

The moment of imbalance between the momentum and mean reversion tendencies is the ideal opportunity for exiting the market since we’ll likely see a start of a trading range very soon.

Topics Covered

What Is Mean Reversion Trading And How Does It Work
Identifying an Asset’s Trend
Common Pitfall to Avoid In Mean Reversion Trading
Tips For Successful Mean Reversion Trading
Using Channels/Bands
Mean Reversion Setup
Risk Management For Mean Reversion Trading
Advantages Of Mean Reversion Trading
Disadvantages Of Mean Reversion Trading
Conclusion

What Is Mean Reversion Trading And How Does It Work

The market is subject to a statistical phenomenon known as mean reversion, where excessively high or low prices will tend to pull back toward an average price.

This phenomenon is often observed in markets that experience short-term fluctuations or momentum price movements and is driven by a variety of factors, including:

Trader Sentiment:

When traders become excessively bullish or bearish about an asset, it can create a ripple effect in the market and cause prices to move away from the mean.

Supply and Demand:

Changes in supply and demand can also cause mean reversion in trading. For example, if there are large available shares of a stock and not many buyers, prices may temporarily drop below their average value, but eventually, return to the average as demand catches up due to the lower prices.

Market Shocks:

Unexpected news events or changes in government policies can cause temporary price movements that eventually revert to the mean.

Technical Indicators:

Mean reversion can also be identified and traded through the use of technical indicators, such as Bollinger Bands, Keltner Channels, or Relative Strength Index (RSI), which help identify overbought or oversold conditions in the market.

By understanding the underlying causes of mean reversion, traders can develop effective trading strategies that take advantage of these short-term price movements even in the stock market.

When the two forces of momentum and mean reversion are in balance, we will see a trading range begin. Any of you that have been chopped up in an instrument that is in equilibrium, know how painful that can be.

Identifying an Asset’s Trend

Mean reversion is not to be confused with a true change in trend.

After a momentum move in the asset price, it is common to observe some degree of overextension. This can be seen as the market attempting to go too far and subsequently being faced with increasing resistance or decreased demand.

The result of the overextension is often mean-reversion that pulls the market away from its established trend direction. It does not always equal a change in the long-term trend of the instrument.

A period of price correction often helps create stability for the future movement of the instrument, as lower prices in an uptrend attract fresh buyers/new positions.

MEAN REVERSION

This chart has a 48% increase in price with momentum over 13 trading days. With a long run-up and no down days, it is a prime candidate for mean reversion.

A complex correction shapes up and the price begins to chop around the 20-day simple moving average – the average price of the last 20 trading sessions.

Momentum steps in again and the price is currently up 38% at the time of this screen capture. The overall trend remains intact as evidenced by the price making a new higher high.

Here is a daily chart of Apple showing momentum to the upside and mean reversion.

aapl mean reversion

Even though we understand that market prices naturally revert to their averages, it can be hard to precisely predict when or what the average price will be.

There are many analytical tools available for us to make educated guesses about the mean reversion profit targets and when the mean reversion will happen. Ultimately, this is still only a guess and any predictions should not be taken as certainties.

But knowing the price is not the point. We aren’t looking for homerun hits trading against the trend with a reversion to the mean.

Common Pitfall to Avoid In Mean Reversion Trading

While it is true that mean reversion is a force in the market, a market that is by way of momentum can work off that move in other ways.

failure

When prices lose momentum, it will often either fall into a trading range or form a bull flag continuation pattern. These are two of the most common ways that price will work off momentum.

On the left, the price mean reverts more than half of the 45% increase in price.

On the right, we see a bull flag and with the last one, we see a trading range form.

The takeaway is that you don’t blindly trade a potential mean reversion just because the market had momentum. You need to see some type of reversal setting up to increase your odds.

Tips For Successful Mean Reversion Trading

When it comes to mean reversion trading, one of the key challenges is determining when an instrument is overextended and likely to revert to its mean. This requires analysis of various technical indicators, including moving averages and bands or channels, and price action.

One common approach is to look at the distance between the price and a moving average, which can help to identify when an instrument is potentially overextended.

moving average momentum

Mean reversion strategies require an overextended instrument but what is overextended price?

This is where bands or channels can come in handy.

Using Channels/Bands

Bollinger Bands are a popular method for determining whether a market is extended and potentially a mean reversion play. Bollinger Bands are created by adding or subtracting a certain number of standard deviations (2) from an average price.

This indicates that the price may be overbought or oversold and ready for mean reversion.

When the price of an instrument reaches a certain distance from the Bollinger Bands, traders will look for a setup to position against, as this suggests that the market is overextended and due for a mean reversion.

But you need an entry signal.

This might involve looking for a reversal pattern, such as a double top or head and shoulders, or waiting for the price to move back toward the moving average before entering a position.

The key to successful mean reversion trading is to analyze the technical indicators and determine when an instrument is overextended and likely to revert to its mean.

By using tools like Bollinger Bands and waiting for a reversal setup to develop, traders can improve their chances of success and generate profits in the market.

bollinger band

If the price of an instrument is poking outside of either the upper or lower band, it could indicate a potential mean reversion trade.

However, it’s important to exercise caution, as simply shorting or going long based on this signal alone can be risky and lead to losses.

Keltner Channels can also be used and is my favorite trading indicator. I am not a fan of the balloon effect of the Bollinger Bands and I like the ATR feature of the Keltner.

This is a 20-period channel set to a multiplier of 2.5.

keltner channel

You would treat the excursion beyond the channels the same way you would with the Bollinger or any other band.

The middle line in the channels would be a profit target to consider.

Mean Reversion Strategy

Imagine your mean reversion trading strategy has identified an extended instrument that had increased momentum price movement.

That is not enough of a standalone condition to have you pushing the trading buttons.

We need an actual setup to get involved with and your trading rules should contain what that setup is.  Whether day trading or swing trading, the setup can be the same.

There are a few ways to look at trading this move and one of them is the 2B price pattern.

FAILURE TEST SHORT

Remember, the first step in a mean reversion trading strategy is to look for the price to run up and break the upper Keltner Channel, as this suggests an overextended market.

The stock prices here had run up 62% and broken the upper Keltner Channel. We can consider this the first part of our setup.

Price has a small retracement, breaks the newly formed high and we see a reversal candlestick taking place.

Traders would place a sell stop to enter short below the reversal candle. If the price reverses and continues in the trend direction, we want out. Protective stop loss will be just beyond the high of the reversal.

Another example with the reversal candle being a bearish engulfing. The trade entry and protective stop loss is the same as in the previous example.

mean reversion short

If a trader is wanting to see an ideal setup for a mean reversion trade, it would look similar to this.

perfect setup

Typically, at the end of a move, the price of an instrument will run up with momentum and break through the channels.

Following this, we would like to see a slight pullback that results in new candle lows. The price would then continue to rise slightly, taking out the most recent high before eventually reversing.

While there may be other ways to trade an overextended instrument, the 2B (failure test) setup would be one of the better ways.

Why should this work?

If we consider what the price is showing:

+ Price rises and breaks the channel/bands. Traders sitting on the sidelines are suffering FOMO from missing the first move

+ A slight retracement takes place bringing new buyers into the instrument

+ Price makes a new high bringing breakout traders into the mix as well as they think a new trend leg is about to occur

+ Quick reversal has longs exiting their trades while those that traded mean reversion, are quickly into profit.

Risk Management For Mean Reversion Trading

With a reversion strategy, often the best course of action is to reduce the position size since they are against the larger trend.

By taking half of your usual position size, you can better manage any possible losses if the triggered trade does not play out as expected.

Since different time frames are reacting differently to this price action, there may be a second opportunity above (or below) what was my original trade.

This would provide you with the potential to get back in on another setup should it present itself.

Advantages Of Mean Reversion Trading

Increased Probability of Success: By focusing on short-term price movements and taking advantage of mean reversion opportunities, mean reversion traders can increase their probability of success and generate profits more consistently. Traders should expect some adverse movement from an extended price condition.

Reduced Risk: Mean reversion trading strategies typically involve shorter holding periods and tighter stop-loss orders, which can help to reduce risk (especially using half position size) and limit losses.

More Opportunities: Mean reversion trading opportunities can be found in a variety of different markets and asset classes, providing traders with a wider range of opportunities to generate profits.

Disadvantages Of Mean Reversion Trading

Limited Profit Potential: Mean reversion trading strategies typically focus on short-term price movements, which can limit profit potential compared to longer-term trend-following strategies.

False Signals: False signals are a common issue with mean reversion trading, as price begins to mean revert but then reverses strongly to the upside/downside

High Risk: Mean reversion trading involves taking positions against the prevailing market trend, which can be risky and lead to significant losses if not managed properly.

Conclusion

Mean reversion trading can be a profitable strategy for traders looking to take advantage of short-term price movements in the market. By carefully analyzing technical indicators and waiting for clear setups to emerge along with buy and sell rules, a mean reversion trading strategy can increase your chances of success and generate consistent profits over time.

Risk management is key when trading against the prevailing trend and traders should adjust their position size accordingly. Also, false signals are a common issue with mean reversion trading, so it’s important to have a good understanding of technical indicators such as a moving average and price action for higher probability trades.

Mean reversion can be a great tool for successful traders, however, they should always remember to trade responsibly and manage their risk appropriately.

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Published May 2022| Updated Mar 2023



Author: CoachShane
Shane his trading journey in 2005, became a Netpicks customer in 2008 needing structure in his trading approach. His focus is on the technical side of trading filtering in a macro overview and credits a handful of traders that have heavily influenced his relaxed approach to trading. Shane started day trading Forex but has since transitioned to a swing/position focus in most markets including commodities and futures. This has allowed less time in front of the computer without an adverse affect on returns.

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