The price is fluctuating constantly on the price chart. Even when there is a strong trend visible, the price makes rotations. This phenomenon is called a mean reversion. How to use it in trading? Read the article and you will learn.
Key Takeaways🔑
| →Mean reversion is a trading strategy that takes advantage of price rotations back to the mean level. |
| →Mean reversion traders aim to enter short trades during uptrends and long trades during downtrends. |
| →Using exponential moving averages (EMAs) can help identify potential entry and exit points for mean reversion trades. |
Contents
Mean reversion explanation
The price is moving up and down also during a strong trend. It is reverting back to the mean. The higher price will rotate occasionally lower and the lower price will rotate higher before continuing in the previous direction.
Consider the example below. There is an EMA added to the chart. You can observe a strong uptrend. But the price, before it moves higher, is rotating lower to the mean.
The difference between momentum trading and mean reversion trading
Momentum traders look at the overall trend. When the price is rising, they search for the possibility to open long trades when the price is moving even higher.
Mean reversion traders wait for the price to rotate lower (during the uptrend) to enter a short trade.
Mean reversion strategy in Forex
Forex is one of the most popular markets where traders use the mean reversion strategy. The reason is frequent significant movements of the price.
The price rotates back to the mean level (which is the EMA200 in the example below) even after especially great move higher.
Trading with the mean reversion strategy carries a bit bigger risk since it requires you trade against the prevailing trend. You need to observe the tops and bottoms in the market as well as changes in the direction of the price.
The best indicator to apply when trading the mean reversion is the exponential moving average.
Trading with the mean reversion on the Olymp Trade platform
The moving average is often used by traders to identify the trend and to trade with the current momentum. But as I have told you before, it is also a good tool to trade mean reversion.
To do that, attach two exponential moving averages to your chart. One with the period of 200, and the other one with the period of 50.
How to go long with the mean reversion strategy
Let’s look at the exemplary chart below. The price is moving below the EMA200. The EMA200 shows a significant downtrend. The EMA50 is running below the EMA200 and falling. When it changes its direction and begins to rise, you can open a long trade with the stop loss just below the previous low. You can try to realise your profits when the price is reaching the EMA200.
How to go short with the mean reversion strategy
Below you will find another example for the AUDUSD currency pair. The price is moving above the EMA200. The EMA200 indicates a powerful uptrend in the market. The EMA50 is placed above the EMA200 and rising. The moment you should open a short position is when the EMA50 changes its direction and begins to fall. Set the stop loss just above the previous high. You should try to realise your profits when the price is reaching the EMA200 on its way down.
Pros and Cons of Mean Reversion Strategy 🔄
Consider the advantages and disadvantages of the mean reversion strategy:
👍 Pros:
- Offers potential profit opportunities during trending markets
- Allows traders to capitalize on price rotations back to the mean level
- Can be used with various time frames and financial instruments
👎 Cons:
- Requires careful analysis and understanding of market trends
- Carries higher risk as it involves trading against the prevailing momentum
- Not suitable for ranging or sideways markets
Comparison of Mean Reversion Trading 🔄
| Aspect | Mean Reversion Strategy | Momentum Trading Strategy |
|---|---|---|
| Focus | Price rotations back to the mean level | Overall trend direction and momentum |
| Entry Strategy | Enter trades against prevailing trend during price rotations | Enter trades in the direction of the overall trend |
| Risk Management | Set stop loss and take profit levels based on mean reversion analysis | Use trailing stops or support/resistance levels for risk management |
| Market Conditions | Suitable for trending markets with price rotations | Suitable for strong trending markets with momentum |
Final words
The mean reversion strategy works best when the market is trending. Avoid trading with it when the price is ranging.
You trade against the current momentum and so the risk you need to be ready to take is a little bit higher than when you trade with the trend.
Use the exponential moving averages to catch the best moments to enter your trades.
Remember about demo account which Olymp Trade has in its offer. It is available for free and you get the chance to see how the mean reversion strategy works without risking your own money. Once you get to know the strategy, you can switch to the real Olymp Trade account.
Leave a comment below. I would be glad to hear your thoughts on the mean reversion trading strategy.
Good luck!
Q&A on Mean Reversion Strategy 🙋♂️
Here are some frequently asked questions about the mean reversion strategy:
- Q: What is mean reversion in trading?
- A: Mean reversion is a trading strategy that focuses on price rotations back to the mean level, aiming to capitalize on the reversal of temporary price movements.
- Q: How do you identify mean reversion opportunities?
- A: Traders can identify mean reversion opportunities by looking for price rotations away from the mean level and then waiting for the price to revert back to the mean.
- Q: Which indicators are commonly used in mean reversion trading?
- A: Exponential moving averages (EMAs) are often used to identify mean reversion opportunities. Traders may use a combination of different EMAs to determine entry and exit points.
- Q: Is mean reversion suitable for all types of financial instruments?
- A: Mean reversion can be applied to various financial instruments, including stocks, forex, commodities, and indices. However, the suitability of the strategy may vary depending on the characteristics of each instrument.
- Q: What are the risks involved in mean reversion trading?
- A: Mean reversion trading carries the risk of mistaking temporary price fluctuations for a genuine mean reversion. Traders should carefully analyze market trends and use proper risk management techniques to mitigate potential losses.