A mean reversion trading strategy aims to identify the entry and exit points that are characterized by divergences from a defined mean. Below are the steps to formulate a mean reversion strategy with ease:
1. Determine the Mean
The first task is to decide on the type of mean which may either be a simple moving average or an exponential moving average. Time frame also matters a lot. For instance;
Short term averages (say 10 days) can be used for trades with a high turnover rate.
Long term averages (say 200 days) might be more appropriate in positional trading.
2. Establish Limits for Deviation
The next step is to establish the level of deviation which can be considered a signal for action. Traders can utilize standard verticals whereby for normal settings, traders can set +-1 or +-2 standard deviations from the mean.
For example, a stock that has increased in price up to two standard deviations within the average could be considered overbought.
3. Outline the Entry and Exit Rules
Within the sphere of mean reversion trading strategies, prepare well written entry rules and exit rules. An example of such could include:
Entry: The amount exceeds the average by two standard deviations, the difference being the mean.
Exit Point: Sell once the price touches the mean or reaches the target level that they have set for profit about a trade.
4. Incorporate Stop-Loss Measures
There is a need to include the stop-loss orders as a risk management tool incase the price does not revert to the mean and continue going deeper. Mean reversion strategies, though very effective in most cases the market can be trending which means a stop-loss should be used to limit the law.
5. Test the Strategy
Also important is the backtesting of the strategy to establish if it will bear fruits in the current market. Historical data is critical in this case, to validate the strategy’s effectiveness and how it would fare across multiple market environments. Put into consideration, the win ratio, average profit per single trade, and biggest drawdown to further polish the strategy.
Mean Reversion Strategies Drawbacks
As promising as mean reversion strategies can be, they also have some drawbacks:
False Signals: The volatility of the market many times makes the traders to see the prices as overbought and never retrace the prices back to actual levels. With the false signals, it ushers unnecessary trades which increases redundancy in transaction cost.
Trending Markets: Enough time may be lost in for example depressed markets where mean reversion may be present but for long times the peaks are just not reached hence leading to losses.
Transactional Costs: The costs can be very high especially if the reversion is frequent. Losses can be sustained in trading because of these trade costs.
In order to take care of such issues, traders opt to combine mean reversion strategies with additional indicators or other strategies in order to add to the accuracy of the trade.
Mean Reversion Strategies Examples
Mean reversion strategies include the following two Moving Average Crossover and Bollinger Band Reversal.
Moving Average Crossover Strategy: This strategy involves two moving averages of different periods, the shorter one and the longer one. A bearish trade is signaled when the short term moving average moves below the longer term average since a sharp downward move has been overextended. On the other hand, when the shorter moving average moves above the longer moving average, a sell position is warranted since an uptrend has been overextended as well.
Bollinger Band Reversal Strategy: While using Bollinger Bands, traders wait for the price to reach the lower band in order to buy and sell when the price passes the upper band. The bands show areas of over and under pricing activity and so the general idea is that price will always revert to the average over time.
The above strategies present a systematic way of making profits from mean reversion trades but they must first be tested and modified to cater for particular assets and current market conditions. There are numerous automated trading software solutions available in the market to handle the complex analyses mentioned above.
Conclusion
Mean reversion is a powerful neoclassical strategy, assuming that asset prices will return to their vernacular level over a period of time. In anticipation of such price moves, traders apply technical indicators such as moving averages, Bollinger bands, and relative strength index and develop trading plans which take advantage of price movements. As much as mean reversion strategies are fairly profitable, they need to be applied alongside adequate risk management as well as backtesting because prices do not easily revert to the mean in most cases, particularly in trending markets.
However, by applying the knowledge of the core ideas and methods of mean reversion, traders are in a position to design and implement successful strategies for the generation of profits in different market environments.
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