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Mean Reversion Strategy and How to Effectively Use It

Reversion to the mean is the process of returning a condition to its long-run average state. Mean reverting does not only consider percentage returns and prices; interest rates and even a company’s P/E ratio can be affected by sensation. Simply, reversion to mean trading boils down to the old aphorism:

“Everything that goes up must come down.”

Many trading strategies rely on mean reversion theory, which involves buying and selling asset class prices that have deviated from their historical averages. The idea is that prices will eventually return to their previous averages and normal patterns.

Mean reversion trading strategies include the following:

  • Reversals.
  • Oversold and overbought approaches
  • Retracement.
  • Strategy for trading ranges.
  • Trading on the pullback

The best mean reversion strategy is to trade price ranges that occur after a significant price increase or decrease. Reversion to the mean, in this case, implies trading near the middle of the range as our average price.

Economic Cycles and Mean Reversion

To understand and develop high-winning skills in mean reversion strategy, you have to understand the following rules:

1. The market is above the 200-day moving average;

Invariant if the stock market is in a long-term uptrend, it does experience bear markets from time to time (or a recession). In other words, we only want to buy when things are adequate and stay out of the market when things are worse and are better for Economic Cycles and Mean Reversion.

But what exactly do we mean by “adequate”?

As a tendency filter, we can engage the 200-day moving average. If the price is higher, we will extrapolate that the market is in an uptrend.

2. 10-period RSI is below 30

The RSI (relative strength index) can be used to demarcate the profundity of the pullback. Thoroughly, When the 10-period RSI falls below 30, it signifies that there is strong bearish momentum (over the last 10 days).

Regardless, as you are aware, the stock market is in an uptrend in the elongated run. Waiting for the 10-period RSI to fall below 30 allows us to enter our trade at a “lower price” and profit on the next upswing.

3. Buy at the following day’s open

This MRT rule is quite intriguing. You’ll have to wait until the market closes to see if the RSI indicator has closed below 30. This represents that the earliest you can enter a trade is on the next day’s opening, which is exactly what we’re doing here.

4. When the 10-period RSI crosses 40, exit the trade (or after 10 trading days)

The goal of mean reversion trading is to capture “one move” in the market and nothing else. We can also define the “one move” using the 10-period RSI. The desired condition is for the 10-period RSI to cross above 40, which occurs only after a market rally. By following strategy, you can learn a lot about Economic Cycles and Mean Reversion

Do Mean Reversion strategies work?

The flipping of coins is a perfect illustration of mean reversion:

Flipping a coin under the assumption of fair play yields a 50/50 chance of either tails or heads. There is a 67% chance that the interval will be 55:45 head or tail if 100 coins are flipped (one standard deviation). There is a 95% (two standard deviations) chance of being inside 60:40, and a 99% chance of being inside 65:35. (three standard deviations).

Despite short-term “runs” that can deviate significantly from long-term statistics and probabilities, the more times you flip the coin, for example, 10,000 times, the closer you will get to the average of 50:50.

This is also known as the law of large numbers, an important trading concept.

Certain markets are naturally mean-reverting, whereas others are not. In the short term, stocks are highly regressive to the mean, whereas commodities are much less so. Fortunately, you can successfully employ both momentum and mean-reversion when trading stocks. In addition, the stock market comprises numerous sectors and industries that are not highly correlated (business-like).

The latter statement is not contradictory to Reverting to the Mean. In the short-term (less than three months), the market is highly mean-reverting, whereas momentum appears to work best in the 3–12 month time frame. When analyzing more than a year’s worth of stock trends, i.e. The upward bias from inflation and earnings causes an increase in stock prices. The overnight edge has been persistent and prolonged.

Understanding Mean Reversion

Mean reversion, also known as reversion to the mean, is a finance theory that proposes that asset price volatility and historical returns will eventually revert to the long-run mean or average level of the entire dataset.

Mean reverting does not only consider percentage returns and prices; interest rates and even a company’s P/E ratio can be affected by sensation. This mean level can appear in a variety of contexts, including economic growth, stock volatility, a stock’s price-to-earnings ratio (P/E ratio), and industry average return.

Reversion to the mean is the process of returning a condition to its long-run average state. The concept assumes that a level that deviates significantly from the long-term norm or trend will revert to its understood state or secular trend.

The theory has given rise to a plethora of investing strategies involving the purchase or sale of stocks or other securities whose recent performance has swerved significantly from their historical averages while Reverting to the Mean. A change in returns, on the other hand, could indicate that a company no longer has the same potential it once did, in which case mean reversion is less credible.

Disservices of Mean Reversion

Since mean reversion strategies necessitate a large stop loss to avoid being stopped out too early, you will need to maintain a smaller position size than you would with other strategies to avoid exceeding your risk limit. This is an obvious disadvantage, as a small position size also means you will earn less on each trade.

Typically, you enter mean reversion trades when everything appears ugly and pessimistic, making it difficult to pull the trigger.

Another disadvantage is that the mean reversion strategy tends to perform poorly during periods of low volatility. You need volatility so that the market will make the swings you attempt to capitalize on.