Most of Forex traders have probably noticed that asset prices are keen on coming back to certain levels from time to time. That feature is used in a Mean Reversion Strategy - a system based on defining average price ranges. This article is aimed to explain how that trading method works, what are the best steps to arrange it in terms of profitable Forex trading and which technical indicators are worth considering to build an effective trading algorithm.
Even during a strong trend, price charts can be divided into two channels with a clear central line dividing them. It does not necessarily have to be a horizontal line, it could be an ascending or descending so-called median line. What’s more, it does not have to be a straight line as it could be a curve like moving averages look like, for example. In any case, asset prices spend much more time around those average ranges rather than in a far distance from them. Thus, it is possible to assume that after every breakout or acceleration, prices should come back to the average mean wherever the trend is directed.
What is a Mean Reversion Theory?
There is a widely-used theoretical concept in financial science called regression to the mean. The main idea is coming from statistics and it is based on the observation that extreme values of any row of figures are comparatively rare, while average means are the most common in terms of occurrence frequency. In other words, the Mean Reversion Strategy suggests that random values are mainly concentrated around average ranges. Translating that into the trading language, asset prices should fluctuate within an average range for most of the time, while sharp rallies are mainly short-lived.
Extreme events happen in our daily life. A football team could lose a match with an enormous number of goals conceded. But most of the following games will end with an average number of goals scored. An extreme temperature could be noticed in the middle of a summer season, while other days will be quite normal for the current season. The number of daily car accidents might jump in one day, but the average daily figure will remain almost the same in the long run. When it comes to a security price, it could soar one day amid sudden geopolitical or macroeconomic event which does not come in line with previous occasions. However, rates will gravitate to a certain average mean corresponding to the recent long-term trend.
Drawing a median line
The average range of means does not have to be static or horizontal. It could be represented as a growing or declining line on a price chart. This is not a traditional trendline, which reflects resistance or support levels. This is more of a median line. In contrast to support or resistance trendlines, which are built by connecting only highs or lows, the median line connects a bottom with a top in case of an uptrend or a top and a bottom in bearish market conditions. It’s worth mentioning that a too sharp angle of a median line would not add efficiency to the line as most of the long-term trends are gradual. So, before building a median line, forex traders should consider which extreme points is it reasonable to connect. An example is shown on the daily chart of gold below.
The blue dashed median line connects the bottom of the market on August 16 and the top on March 25. During that uptrend, the price of gold was edging higher and plunging below the median line several times. However, it was always coming back to it. What’s more, the median line divides the uptrend into two channels, almost equal by the distance of extreme deviations. And the most interesting part of the analysis is that the median line acted as support for the price of gold several times in the future. Thus, this line shows an approximate trend angle used in Mean Reversion trading.
What is a Standard Deviation?
Before we continue with the strategy details, we need to explain one more important mathematical formula present in many technical indicators suitable for Mean Reversion strategies. A Standard Deviation is a set of iterations to calculate the recent level of price rejection for the given period. In other words, the farther the price goes out of the average range, the more the Standard Deviation is. It’s used to formulate the current level of volatility. For example, Bollinger Bands spread the distance between lines exactly when Standard Deviation jumps, reflecting the change in the recent volatility. In such cases, the prices are usually getting far from the average mean. But when Bollinger Bands lines narrow the surplus, reflecting lower deviation, prices usually retreat to the average line.
How to use Mean Reversion strategy?
The Mean Reversion Trading Strategy aims to determine a price level, which is rather far from the average range and has a high likelihood of reversal. This level can be used whether to take profit from a current trading deal or open a new counter-trend position. Besides, the strategy suggests determining the volume-weighted middle of the current trend, which helps to add with-the-trend positions during retracements. The overall feature of the trading system is multi-purpose, it can be applied to any asset class or timeframe. However, like any other trading algorithm based on the technical analysis, it has to come in line with the fundamental environment as that’s the main driver for any financial instrument. This is why Mean Reversion type of analysis of the financial markets is not so straightforward as its analogue based on mathematical and statistical models. Besides, it’s worth reminding that any trading system has to correspondent with an individual trading strategy, money management and risk management rules.
Best time frames for the Mean Reversion Strategy
As long as the daily chart is the most important in terms of the technical analysis and discovering major trends, the Swing Strategy is the most suitable approach for the Mean Reversion Trading System. The main goal is to find strong trends, hold positions during 2-10 days in a row, and sometimes ignore short-term insignificant fluctuations of the price.
If you like this strategy, you might also be interested in this Doji Candle Pattern Strategy
On the other hand, intraday charts are also full of extreme deviations, which might push rates too far from average daily value. Therefore, such timeframes as 4-hourly and 60-minutes charts are also suitable for the system based on regression to the mean. The only condition is that trading decisions have to be made in correlation to the longer-term trends, while the level of stop-loss and take-profit orders has to be adjusted accordingly.
Technical indicators to use in the Mean Reversion Strategy
Finding the best Mean Reversion Indicator is not an easy task as all of the asset classes are different in terms of trading volume, volatility and vulnerability to macroeconomic reports. Therefore, there has to be a choice of several combinations of technical instruments to analyse the market conditions including Bollinger Bands, Relative Strength Index, MACD, Average Directional Index, Ichimoku Cloud and so on. The wide variety of mathematical formulas make technical indicators offering some strengths and weaknesses to a technical analyst.
For example, ADX uses the Average True Range instead of Standard Deviation in Bollinger Bands. Thus, combining those two indicators might show a wider picture of the recent momentum, volatility and trend direction. MACD and RSI are different in terms of speed of the reaction to the price fluctuations, so they could perfectly combine with each other. Ichimoku Cloud advantage is that it shows the depth of possible retracement level, but it does not point to a price level with an extreme deviation and a high likelihood of a retracement if not reversal.
The best combination of technical indicators has to be chosen depending on the trading approach. If a trader noticed that the price of oil, for instance, surged too far from the average mean, and that action is diverging with the general trend, it would be reasonable to find an attractive price level to open a counter-trend short position. Thus, an oscillator showing an extremely overbought level would help together with an envelope indicator pointing to the fact that the price has gone too far from the usual band. But if a trader missed a lucrative entry at the beginning of a strong trend, he would probably keen on searching for a healthy rebound, confirming the current trend. In that case, Ichimoku Cloud and ADX would perfectly show an entry-level.
Setting periods for technical indicators
That’s the trickiest part of the analysis. Again, financial markets are mostly driven by the emotional impact of human traders as a reaction to some fundamental events. Therefore, the mathematical or statistical model might not work in the scope of determining average mean ranges. Sometimes trends become so powerful that technical indicators keep showing extremely overbought or oversold levels, while prices refuse to come back to average ranges for quite a while. At the same time, all technical indicators are lagging. So, for instance, the middle line of Bollinger Bands follows the trend, declining or growing together with the price. However, if the period is too long, the mathematical formula will take into account previous price levels which are not relevant any more. On the other hand, if the period of an indicator is too short, it would not show the actual width of the current ranges and the support or resistance will be determined wrong.
This is why it is extremely important to keep a certain balance when setting periods for technical indicators. Traditional technical analysis points to a most widely used period of 20 bars (days, hours) for Bollinger Bands and 14 bars for oscillators. Some analysts use a figure from the Fibonacci row such as 8, 13, 21, 34 and so on. Again, setting an effective period should be balanced with the general trading strategy and affordable risk-profit ratio. It would not be wise to set a 5-days period for the ADX or RSI if the goal was to gain several hundred pips as a potential profit.
Profit from trading
One of the main advantages of the Mean Reversion trading Strategy is that it allows benefiting on both sides of the price action. Even though a strong uptrend brought a decent profit to a trader, the analysis based on regression to the mean can effectively find a reversal point. So a trader might not only take profit from the previous deal in time but also open a counter-trend deal, counting on a technical retracement to the average range. And the trading cycle could be repeated after the rate reached the median line, where the counter-trend deal is closed, and a fresh with-the-trend position is opened.
Forex traders have to remember to control the greed/fear balance, making pauses between the trading decisions. So if a previous by-the-trend deal was in the money, adding 200 pips to the account balance, the deal based on rebound has to be tighter in terms of take-profit order as the general trend direction could still weigh on market players. A the same time, setting unrealistic goals would not help to implement the money management rules. For example, it’s hard to expect the slow-moving USD/CHF to perform in the same was as the fast-floating GBP/JPY currency pair in terms of daily pips gained.
Examples of trading with Mean Reversion
Here are several examples of profitable trades using the Best Mean Reversion Strategy.
Going short and long on EUR/USD on extreme deviations
The daily chart below shows a long-term downtrend of EUR/USD based on fundamental drivers. The blue descending line, which used to act as the resistance before, started working as the median line dividing the recent downtrend into two equal parts. The initial short position was opened when the pair bounced back to the middle of the range, while Stochastic RSI reached the overbought level and its lines performed the bearish crossover. The profit was taken when the rate reached an extreme deviation from the average range, while Stochastic RSI confirmed the deal after charting the bearish crossover in the extremely oversold territory. With the opposite extreme bounce, the profit from longs was taken and new shorts were opened.
Adding long positions for gold on retracements
The price of gold was in a strong uptrend since June 2019, which was confirmed by the Average Directional Index as its mainline was far above the threshold, pointing to a strong momentum. The trading technique used in this case is called the buy-dips trading strategy. Several with-the-trend positions were opened after the price of gold was retreating to daily support levels indicated by the Ichimoku Cloud. Confirmative trading signals were coming when ADX changed the colour of the surplus. Short positions were ignored as it was hard to expect a deep retracement during such a strong uptrend.
Advantages and Disadvantages
Below is the list of Pros and Cons of the Mean Reversion approach.
- Multi-purpose application of the theoretical concept;
- Wide range of technical tools to be used;
- Possibility to gain on both sides of the market;
- Determining reversal points, which helps to open counter-trend positions;
- Calculating average price ranges to add long-term with-the-trend positions.
- Complicated multi-factor analysis;
- Need to monitor the fundamental environment;
- Technical reversal signals might not work properly during strong trends.
The Mean Reversion Strategy is widely used in Forex trading. The method of analysing trends is based on a common statistical and mathematical model, which applies to any kind of asset and timeframe. The feature of any market to perform the regression to the mean helps traders to assess extremely overbought and oversold market conditions when the likelihood of reversal is high. Calculating average price ranges is useful in daily Forex trading as well as swing strategies. However, the financial markets could be driven by the fundamental side of things, and sometimes mathematical models might not work properly as the emotional impact could outweigh the technical analysis. Therefore, forex traders should apply other methods of analysis, and make trading decisions following the general trading strategy and money management rules.