Skip to main content

Mean Reversion Strategy


There are many different types of trading strategies. Some traders trade with the trend buying high looking for higher highs or sell new low prices short looking for even lower lows in price, momentum strategies just look for a strong move to go a little farther, others trade a market inside a price range of support and resistance. What this article is going to talk about is the specific strategy of mean reversion, this is looking at prices as a kind of rubber band that stretches only so far and eventually snaps back to a historical long term average. 

Mean reversion trading strategies consist of signals that bet on extended prices eventually snapping back from overbought or oversold conditions and reverting back to the mean of historical pricing. It is a trade that takes a position on a quantifiable technical signal that price has moved too far and too fast in one direction and the probabilities that it will return to an average are high. 

One simple way to look for a reversion to the mean trade signal is by setting visual deviations around prices using technical indicators like Bollinger Bands or Keltner Channels that usually measure the distance from the 20-day moving in standard deviations of price. 

When a market drops dramatically or rises parabolically three or four deviations from the 20-day moving average the odds are that it will revert back to that average in days or weeks the majority of time. Of course this does not always happen as markets rotate from ranges to trends, and can go farther than anyone thought possible so you must always use a stop loss for the times when a trend continues and does not revert. 

One strategy is to buy dips to the lower 3rd standard deviation Keltner Channel or sell rallies short to the upper 3rd standard deviation Keltner Channel and set a stop loss if price closes back outside your entry channel signal. Your profit target could be back to the 20-day moving average. 

There is no magic or Holy Grail in reversion to the mean strategies and profitability comes from creating good risk/reward ratios, if it does not work out you should be stopped out for a small loss but if it reverts back to the mean then you should have a big win.  

A mean reversion entry is taking a trade that is at short term extreme prices that has a good chance of returning to more normal long term price metrics.

This Strategy can be used with 1:2 , 1:3 type of risk reward ratios and has a 70-80% winning ratio.

Share this Article with your Friends.


stockmarketadvisory.in

Comments

Popular posts from this blog

Bull Call Spread Options Strategy ( With Practical Example)

I Strongly believe , to be Successful in Stock Markets you Require two things : 1) Edge 2) Hedge Edge means having your own Trading System , following your own consensus & Conviction. Hedge is like an Insurance Policy , it will protect you from losing big and also maximise your earning potential over time without Destruction of your Capital. I will be Sharing one of the Hedging Strategy here. Example : Nifty on Friday (5th June) has closed around 10150. You are Bullish for this Weekly Expiry and what you to do is buy a Call Option of 10200 which is Trading around ₹120. Buying or selling naked Options involves high risk as its equal to betting. If you win you win Big or else you lose Everything. So buying naked Options isnt my Cup of Tea. What will I do in this Scenario? I would buy a 10200 CE (11th June Expiry ) at ₹120 and would sell a 10300 CE (11th June Expiry) at ₹80 to manage my risk. Now there are 3 Situations which can happen : 1) Nifty continues to rise: The 102

Pre - Budget Analysis (1st Feb 2022)

U.S Markets closed higher yesterday. Most importantly , S&P 500 VIX crashed 10%. There was huge Volatility in global markets due to Fed event. Markets remain volatile only when they have topped out or have bottomed out. Right now I feel we have bottomed out at 16850. Asian markets are slightly lower now. Dow futures are lower. SGX Nifty is at 17500. Finally , the most awaited day has come. Budget 2022 is going to be presented today. Expectations are of a good and stable budget. Reasons are the Elections coming up and LIC IPO in March. Govt very well knows if LIC IPO has to go through , Market sentiment has to be good. Without good market spending it would be very difficult for IPO to go through. Market had already fallen a lot before the budget. Although we have rallied in last 2 days but still we have some upside left. Though I feel it's not favourable to chase today's gap up. Today's gap up is a good opportunity to book profits those who carried longs. Bud

Pre - Market Analysis (17th Feb 2022)

U.S Markets closed flat yesterday. Right now Dow futures are slightly lower. Asian markets are slightly higher. SGX Nifty is near 17380. Suggesting a flat start for the day. Yesterday was a heavy Volatile session. Markets have moved all over the place yesterday. At one point of time Nifty rallied and at one point of time we were ready to cross 17500. Then news of Russia came that Russia has not fully taken back their military troops. This led to a drastic fall in the last 2 hours. Nifty crashed all the way to 17300. India VIX came to positive. U.S Markets at one point of time were down quite significantly yesterday. But later during the day they have recovered most of their losses. Most importantly , U.S VIX fell 5% yesterday. Here as well we can hope markets to stabilize and VIX to collapse. Premiums are quite attractive considering only 6.days left for expiry  1000 points away put options are also trading at 20-25 rs premium. These put option buyers you know are crazy peo