Ready to learn intraday mean reversion strategy?
An intraday mean reversion strategy is a technique used in lower time frame of a trading day to capitalize on the opportunity that asset prices often revert to average levels.
The average levels may be levels which are measured using technical indicators such as SMA, Bollinger Bands and other technical indicators.
However, intraday trading may only be predictable when there are patterns that exist from the previous day.
The previous day’s pattern may reveal the type of momentum that may exist.
For example, if the previous day has strong upward momentum, traders can look for long trades.
However, there is a need to watch the trade window to assess whether there is strong buying or selling pressure.
Assessing the strength or weakness of a security is a trading strategy that requires skill or study.
Studying the price action after observing the previous day gains or loss can help traders predict the probable direction of the market in any trading day.
- 20% Gain from the Previous Day
- 20% Loss from the Previous Day
- Feel the Market
- Buy at support or sell at resistance
What does intraday mean?
As a general rule, intraday trading is a trading period which is within the trading day or day trading. (source)
This type of trade opens and closes trading positions by the close of the trading day.
Because the period is too short, a day trader often uses a one minute to 30 minutes intraday chart.
Aside from using lower time frames, they also have the time and sales window to help them decide when there is a profitable market activity.
This profitable market activity is one of the important concepts of intraday trading.
Because it is too important, we need a separate topic to further explain the techniques below.
Margin requirement: Intraday trading usually requires a $25,000 trading account and the pattern day trader rule may also apply.
When the rule applies, a stockbroker may not allow additional day trades, which may increase the losses of the day trader.
Let’s examine the strategies below to find the right stock.
20% Gain from the Previous Day
An intraday trader needs a profitable pattern to make good trading decisions every trading day.
One pattern that is helpful to intraday traders is a security which has a 20% or more gain from the previous day.
Two things usually happen after there is a 20% gain of security.
- Profit taking
- Strong buying
In this post, since the topic is about intraday mean reversion, the focus will be on profit taking.
Profit taking is an event which can cause the price of a security to revert to the average price.
Traders may ask, why does reversion happen in the stock market?
Well, as an example, a security seldom moves more 20% or more in a day.
Because of these extraordinary gains, professional traders often take their profits the next day.
However, if the market strength is real, the pros usually hold their positions, instead of a day trade.
When the strength is not real, there is a high probability of a mean reversion trade.
Mean reversion often happens when there is no good news about a stock or asset.
Good news usually moves the market up, yet when there is no new information, the asset may pullback which is useful for mean reversion traders.
20% Loss from the Previous Day
An asset or security that is down 20% or more from the previous day is also an opportunity for mean reversion trade.
The trade is usually possible when there is no significant news about a company.
However, if there is fraud, then shorting the stock may be a decision that a trader should make.
Often, traders usually buy the stock when the news is not really damaging to the company.
For example, news about missing earnings by 1%.
The same with 20% or more gains, professional traders often take their profits after -20% loss from the previous day.
Feel the Market (Advance techniques for liquid stocks)
Mean reversions on lower time frames require constant attention from the traders, in contrast with short-term swing and positional traders.
It is constant because there is a need to watch the time and sales window, when the price of a stock is at the high or at the low.
Time and sales window will reveal the strength or weakness of the market.
For example, when the time and sales window is moving fast towards the high, there is a strong possibility of a breakout.
And when there was 20% gain from the previous day, there is no mean reversion opportunity.
However, when the time and sales window transactions are slow when the price is at or approaching the high, there is a powerful sign of a pullback.
Thus, there is a mean reversion opportunity when there is no market activity at the highs and lows.
Also, at the intraday highs and lows, selling and buying should happen, respectively.
In stock trading, traders need to learn or understand these type of market activities, with lots of screen time and observations.
Will over-trading be a problem?
Well, 20% of gains or losses normally do not happen every day.
Thus, traders usually can avoid over-trading.
Buy at support or sell at resistance (technical analysis basics)
Buying at support and selling at resistance should not be automatic, although there are 20% or more gains or losses from the previous day.
It is not an immediate trade because traders should understand what they see in the time and sales window.
This is one downside of intraday trading, which requires screen time throughout the day.
Also, there is one principle to an intraday mean reversion strategy.
In the first two hours of the trading day, it is a period where the highs and low are set by the market makers.
After the first two hours, the range becomes smaller and smaller unless there are strong buying and selling.
One can usually observe the price action throughout the trading day.
These observations usually help traders in predicting the direction of the market or improve their trading style.
Remember to set the stop loss on any intraday trading strategy
Mean reversion, specially on intraday time frame are usually high risk for the trading account. It is risky considering the trades are often against the trend.
To minimize the risk, traders need to include or set the price of the stop loss when trading against the direction of the market.
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Related post: 5 Ways to Detect Mean Reversion