Want to learn a mean reversion strategy?
A mean reversion strategy is a trading strategy based on a theory that all security prices often revert to normal levels. When security prices have extreme fluctuations from the normal range or levels, traders can take the opportunity, assuming the price will revert to the mean.
The examples of this strategy may help in understanding its application to trading.
- 90/30 Moving average
- RSI 2
- Price Change
- Buy Four day highest percentage losers
- Buy Minus two times ATR
Everyone wants to earn money in stock trading. For this reason, we need a trading strategy to be successful.
This post will show you the different trading strategies about mean reversion.
What is mean reversion?
According to investopedia.com, Mean reversion is a theory used in finance that suggests that asset prices and historical returns eventually will revert to the long-run mean or average level of the entire dataset.
As an illustration, the extreme changes in the price of a stock can revert to the average.
Mean reversion is assuming that there is an underlying trend in the long term and fluctuations in prices may occur.
Extreme deviation from the average creates a trading opportunity in the short-term.
For instance, an up-trending stock with a recent sell-off often moves back to the mean.
In stock trading, there is a stable trend, but from time to time, price will fluctuate with it to give short-term opportunities.
So, deviating too far from it will most likely revert again to the mean to stay in the long-term direction.
There are trading opportunities in reversion to mean trading strategy to profit in the stock market.
Below, I will show you simple trading techniques, but here, you can read about its difference from trend following to see if you can combine both.
In this mean reversion opportunity, you can have more signals to earn profits in the stocks market.
What is mean reversion trading?
A mean reversion trading is a type of trading that applies the mean reversion theory. Usually, the trading relies upon screening securities in which the prices are too far from the normal level or average for a considerable period. Once identified, one can capitalize on the opportunity.
Trend Following vs. Mean Reversion
Trend trading usually happens during breakouts, while mean reversion is about a stretched moving average which you can expect to snap back.
According to this study, combining both strategies produces approximately 80% win rate.
Why not use the two methods? We use both technical and fundamental information to trade stocks because they have found it profitable.
In that post, the examples showed how cumulative RSI and 200-moving average can increase your win rate to reduce losses.
The combined strategy has been working in S&P500 when the trader back tested it.
Well, I have shared Larry’s 2-period RSI below to show you that using trend and mean reversion trading is reliable.
I also use both analyzes in my momentum trading strategy to find outstanding stocks to buy.
Reversion trading can become a powerful trading strategy in the stock market when you combine it with trend following.
You can look at “what technical analysis do you use” in the search bar to read more about it.
In trend following vs mean reversion, you are using one method only to find trading opportunities.
Why not combine both to increase the probability of winning?
How to Trade Mean Reversion?
Anyone can use technical indicators, financial information, economic indicators, and sentiment indicators to find profitable trades.
In this reversion to the mean trading, you can use different indicators to make money in the stock markets.
The technical indicators we use are the Relative Strength Index(RSI), Moving Average, and Cumulative RSI.
We have back tested RSI2 below to find out if it is profitable and the result is promising.
Also, the indicator performed well in the test period.
In these mean reversion indicators, you can have the best buy and sell signals to profit in the stock market.
Of course, set it properly to get it.
What stocks to buy?
For high returns, choose stocks with high volatility, low liquidity, and low price.
First, only buy stocks that have the potential to move fast. Second, choose the security with a small volume to stay away from high-frequency traders.
In this mean reversion strategies, I stay away from high-frequency traders to avoid trading against supercomputers.
To clarify, a retail trader cannot compete with large institutions in trading.
Stay away from hedge funds that use machine learning and algorithms.
They have designed these programs on computers to extract profits from you and me.
I have shared mean reversion trading systems below to help you understand how the strategies work.
Portfolio selection has two stages, according to Harry Markowi. (source)
The first stage is observation and experience, while the last stage is the belief in the future performances of securities.
We can apply observation and experience to mean reversion systems to optimize a portfolio.
Bollinger band is a mean reversion indicator. The indicator comprises two channels above and below the price.
The channels may show a trend or a trend reversal.
According to The Balance, the Bollinger band is just a tool, and it has flaws. (source)
Because of its flaws, it is a topic excluded from this post for now, though it is popular.
Algorithmic trading may also have mean reversion strategies. An example strategy can be swing trading.
Swing trading is popular among short-term traders, considering the number of strategies available.
For example, selling at the break of the three important moving averages.
Top Mean Reversion Trading strategies
1. 90/30 moving average
The strategy of 90 and 30 moving average illustrates how mean reversion works. First, buy when the 30 days MA is below the 90 days MA.
Second, sell when the 30d MA is above 90d MA.
Third, you can optimize in Amibroker the distance between the two moving averages to find the best settings.
In this mean reversion trading, you are not looking at the price, but I suggest you include support and resistance areas to increase your win rate.
Every time I receive a signal, I don’t trade it without powerful support or resistance levels, but if it does, I take the trade.
I found that mean reversion models are profitable.
I evaluate this strategy in stock trading every six months or a year to see its reliability.
Professional traders do that to know if the system is still profitable.
They do not wait for unforeseen things to happen because they prepare for the worst.
You should not use this strategy in consolidating markets to avoid whipsaws.
Moving average mean reversion works only in trending environments when trading stocks.
In this mean-reverting strategy, look for a trending market in the market to use this system correctly.
When I started trading as a beginner, I read a book about MA20 and MA50, and then I used it immediately in trading, but I did not make any money.
Do you know what happened?
The moving average was flatting out in the charts to tell me that the market is consolidating.
I did not realize it back then to avoid the trade.
If you want to buy a stock using this strategy, then you have to look for upward-trending stocks.
Otherwise, look for down-trending stocks to find selling opportunities.
However, moving average mean reversion is a lagging strategy in stock trading to warn you about trades.
To increase the likelihood of your success, optimize the best settings in Amibroker.
However, see to it if is not a curved fit.
2. RSI 2
We have tested Larry Connor’s 2-period RSI strategy in the Philippine stock market, and we found it profitable.
Also, the method is simple to use based on data. (Source)
- Buy when RSI2 is below 5 and the closing price is above MA200.
- Sell when the cumulative RSI is above 60. (source)
The annual return was 10%, and we noticed it works well in every country.
In this mean reversion example, the video shows how to set it up in Amibroker to write the code of cumulative RSI.
How to compute the cumulative RSI?
When you use the 2 period RSI strategy, use stock screeners because most charting tools don’t have advanced features.
You can use this formula in Amibroker to scan these signals.
I will not share the formula in here because it is very simple.
In this best mean reversion strategy, You only have to add the current end of the day RSI to the previous day RSI and determine if it is below 5.
Well, don’t forget to use the 2-Period-RSI indicator to use this strategy.
Larry uses the 200-period-moving average to filter out weak stocks.
I use this indicator to almost all my strategies to follow the trend.
This mean reversion strategy is easy to implement in stock trading to find good trades.
You only need to trade in the markets after the trading hours.
In this mean reversion indicator, I use the daily close to scan for signals to have time for analysis.
For example, you can scan all the stocks at night to find signals.
Your entry price can be the close of the day.
In this mean reversion trading system, you are looking for signals after market hours to find high probability set-ups.
I usually set my trades at the close price when I see a signal to prepare for the next day.
Once the markets open in the next trading day, I don’t have to set my entry price to buy the stocks, and I make sure that my orders are complete.
You can do it even if you have a current job.
If you have nothing to do daily, then you can connect to real-time data to monitor this strategy.
When trading mean reversion, set your stop loss correctly to protect your trades.
Well, Larry did not specify where to put your stops in this strategy, but you need at least enough room for errors to prevent whipsaws in the price.
In RSI mean reversion, have an exit plan in your trade areas to protect your trade.
3. MA 200/MA 20
- Buy when the price is below MA20 and above MA200
- Sell when the price is above MA20 and above MA 200
Divergence from the long term Moving Average creates a signal to buy the stock.
The theory suggests that the long-term trend is still intact in the charts. However, the short-term trend is bearish.
I found this strategy to be effective in stock trading to use divergence in your advantage.
Why does this work so well?
Well, I can’t reveal who taught me this strategy because it is a secret.
Most traders know about the golden cross in stock trading.
For example, when the 20 moving average crosses above the 50MA, it is a buy signal.
The strategy sounds good right.
Well, hedge funds use this kind of information to their advantage. They know that liquidity comes when that situation occurs to exploit it.
For example, when the price crosses below 20-moving average, hedge fund traders know they can push the market towards liquid areas to trigger a lot of trader’s interests.
When that happens, the price will move up, and they profit, but if it did not spark the interest of traders, they would hunt for stops.
Because big institutions can move the market, they have to disguise their trades to hide their intentions, but most retail traders don’t know about this strategy.
Who spread technical analysis in the past?
Technical analysis has reached thousands of beginner traders through Wallstreet, and do you know why?
They do it in their trading to make money from the unsuspecting traders.
Most trading filters look like this(Price>MA20>MA50>MA100) to find healthy trends. However, it’s not a good place to be when entering your trades.
I don’t use that method because the Moving Average Indicator is a lagging tool.
4. Price change
If the stock moves up 10% for two days and it took six days to decline by 5% to 6%, it is a powerful sign of a divergence in the trend.
However, you need to backtest this strategy to see the behavior of a particular stock.
You can’t use this method on all equities in the market.
For day traders, this is important.
It is profitable because all traders are looking for candlestick patterns and signals from indicators.
You can use this in stock trading to set up your entries ahead of time.
I use this short term mean reversion daily to set-up my trades.
Some traders use price change in trending markets to ride it.
However, sometimes, mean reversion systems also incorporate the speed of price movements.
For example, if the average movement of the price of the stock is $1, up or down.
One day, the stock decreases by $5, more traders will expect the price to increase in the next few days.
All you have to do is get the behavior of the stock to predict the next move.
In this mean reversion model, you are completely looking at the price, but you are not using any indicators to find good trading setups.
5. Buying the Highest Four day Percentage loser
Buying the worst four-day percentage loser is a good mean reversion strategy.
However, test this method in Amibroker to see if it is reliable in your country.
Every four days, you’ll buy the highest four-day losers, but you have to rebalance it every time.
For example, you’ll divide your capital into five to manage your risk.
Then, you’ll buy the highest percentage losers in the last four days and sell all below the top five.
You can also use this strategy weekly to rotate your positions.
Trading four times a month is a good way to reduce trading costs.
What do you call this strategy?
Guess what it is?
It is a swing trading strategy.
Well, have you back tested this system in the past? Or did you know about it?
You do not have to use only moving averages for swing trading.
However, know where to enter and exit your trades.
This strategy is very popular among mean reversion traders.
You can use this system in stock trading on weekly, monthly or yearly.
I hope you have learned a valuable strategy in the markets to improve your earnings.
Of course the opposite is selling the four days highest percentage gainers, but shorting stocks is not an excellent strategy in the long run.
I think I have written a post on this website in the past to prove my point. Well, I even shared some examples.
With this in mind, I have back tested several entries and exits, and I have found a good way to use it.
If you use this strategy, incorporate fundamental analysis to increase the likelihood of success to your trading.
The four days highest percentage losers do not mean that those are bad stocks.
Sometimes, it is the best time to buy the stock to ride the trend.
6.Long stocks at minus two times Average True Range(ATR)
This method is a day trading strategy in the markets to find stretched out stocks.
For example, if the Average true range for 14-periods is $1 and the price move down by $2, you’ll know that the stock will eventually return to the mean.
When that happens, you can buy the security; however, set your stop-loss properly to succeed.
Well, you can use the ATR to do it and probably try one time ATR.
You can use intraday mean reversion strategy when trading stocks to find short-term opportunities.
Well, I don’t recommend it in a higher time frame because it can give false signals.
In my experience, be careful when buying these stocks because it can go in the opposite direction quick.
Exit the trade immediately to protect your account.
However, you can’t detect these kinds of moves if you do not have good trading software.
To find these kinds of stocks, I use Amibroker, but you can also use free online tools.
In TradingView, you can make some scripts to use this strategy, but coding the script is difficult for beginners.
The syntax is almost the same as Amibroker. When I started using trading view, I only use it with Forex because the data is free.
However, I find Amibroker better when trading stocks to backtest and scan for trading opportunities.
You can use VWAP with this strategy to increase your win rate.
You can read more about VWAP in Investopedia to learn how to use it.
Most traders use ATR in stock trading to trail their stop loss, but you can also use it to look for buying signal especially with day trading.
Please backtest it properly before using these strategies.
We will update the strategies here. Keep in touch!
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