November 28, 2021

Return to Average (Mean Reversion) Strategy

Return to Average or Mean Reversion is a financial concept that presupposes that the price of an asset or its gains tends to stabilize over time. When the current market price is greater than the average, we anticipate that it will decline in the future. However, when it is lower, we expect upward growth. In other words, this technical trading strategy bases its concept on the assumption that if a price deviates from the average, it will eventually return to it.

Price mean reversion occurs because of the market’s natural inclination to exceed and underperform its economic worth, respectively. Such price discrepancies arise because it takes time for the market to digest the effects of any new information introduced. The Mean Reversion strategy uses various technical indicators to depict price divergence from the mean value.

Technical Indicators Used For Mean Reversion Trading Strategy

There are numerous variations of the Mean Reversion strategy to utilize depending on the technical trading indicators used. The most common are oscillators and simple trend indicators. You can also choose to use more widespread and advanced indicators or a combination of different trading indicator tools. The strategy uses the indicators to generate market signals.

The stochastic oscillator and the Relative Strength Index are some of the best indicators to identify overbought or oversold instruments. They are also great in identifying entry levels if the trade starts to reverse.

Trend indicators indicate the current state of the market – whether it is trending upward or declining. The most widely used trend indicators are Moving Averages and the complex indicators based on them. They evaluate the current trend and the extent to which the price deviates from the average. In addition, they suggest levels at which to take profits.

Another trading indicator used in the Mean Reversion strategy by many traders is Bollinger bands. The Bollinger Bands indicator is a price chart indicator that displays directly on the chart. The top and bottom lines of the indicator combine to form a sort of price channel, inside which the price chart spends the majority of its time trading.

Traders employ Mean Reversion for short-term trading by utilizing rebounds off the indicator’s top and bottom lines to drive the price closer to the indicator’s mean line.

Buy signal

The following are signs that it is okay to buy

  • Start by opening a buying trade and establishing a stop-loss just behind the current local low
  • Buy when the market is either flat or showing a weak upward trend
  • It is safe to buy when the price dips to the channel’s lower boundary and then bounces back up to the top of the track. It is preferable if a candlestick combo or a price action pattern confirms the bounce
  • When the price reaches the average line of the indicator, it is time to make a profit

Sell signal

  • Initiate a selling position by placing a stop-loss order behind the current high price
  • Sell when the market is either flat or exhibiting a modest downward trend
  • The price climbs to the channel’s upper border and then drops back down to the lower border
  • It is preferable if a candlestick combo or a price action pattern confirms the bounce
  • When the price reaches the average line of the indicator, it is time to make a profit

Pros and Cons of Mean Reversion

Pros

  • The strategy works well in a flat market when there is no clear upward or downward trend
  • It provides a lot of trading opportunities and is one of the best strategies used in algorithmic trading
  • Unlike other strategies, Mean Reversion allows a trader to hold positions for a short time

Cons

  • When the market demonstrates a strong trend, the strategy signals against it, which might lead to losses if the trend continues without a correction and never returns to the mean
  • Profit per trade is smaller than in trend strategies
  • The strategy does not account for new information that might change the long-term estimation of the instrument.

Wrapping up

Mean Reversion is a popular trading strategy though novices might not understand it as much as they know simpler strategies. It bases its concept on Regression to the Mean. More specifically, it focuses on the premise that the price returns to its average after a period of variation. This technique is effective during periods of consolidation, but it may result in losses during periods of high trending, when the price may never return to the mean.