What is the mean reversion strategy?
The mean reversion strategy is a trading method based on the assumption that prices and returns of a security or index return to their average value (mean) over time. This strategy assumes that extreme deviations from the mean are of a short-term nature and that prices will eventually normalize. Mean reversion is particularly common in the stock, forex and futures markets.
How does it work?
Mean reversion traders look for securities whose prices deviate significantly from their historical average. They use various technical indicators, such as the moving average, Bollinger Bands or the Relative Strength Index (RSI), to assess whether a security is overbought (too expensive) or oversold (too cheap). For example, if a security is trading well above its moving average, this could indicate an imminent reversion to the mean and the trader would enter a short position. Conversely, if the price is significantly below the average, a long position would be taken.
Example strategy
A simple mean reversion strategy could contain the following elements:
- Selection of instruments: Focus on highly liquid equities or indices.
- Indicators: Use Bollinger Bands and RSI to identify overbought and oversold conditions.
- Entry points: Buy a stock or index when the price is trading at the lower Bollinger Band and the RSI is below 30 (oversold). Sell or short position if the price is trading at the upper Bollinger Band and the RSI is above 70 (overbought).
- Risk management: use of stop-loss orders to limit losses.
Why do investors use this strategy?
Investors use the mean reversion strategy because it is based on the psychological observation that market participants tend to overreact. This can lead to temporary price distortions that can be exploited by mean reversion traders. The strategy can be particularly effective in sideways or volatile markets where price extremes occur more frequently.
Risks and considerations
The main danger with the mean reversion strategy lies in the assumption that the price always moves back to the mean. In times of fundamental market changes, trends can last longer than the strategy envisages. Furthermore, identifying the “correct” mean value can be challenging. A solid understanding of market dynamics and strict risk management are therefore crucial to the success of this strategy.
Conclusion
The mean reversion strategy offers traders a sound method of profiting from temporary price deviations. It requires thorough analysis and good timing to be effective. As with any trading strategy, traders should understand the risks and apply strong risk management. For beginners, mean reversion can provide an accessible introduction to technical trading concepts, provided they are applied with care and discipline.
