In forex, there are primarily two phases that most traders are habitual to – when the market shows trending patterns while the other one is the congestion period. While the trending phase most likely to sustain less than half of the time, in the congestion period the market seems to swing back and forth. Mean reversion trading implies the concept of how asset price movements are bound to return to standard or mean level eventually in the market. This mathematical conception denotes the market’s tendency of reverting to the norm price after an extreme move is closely related to the timing of the market.
A brief introduction to mean reversion trading
Investors must first estimate the average to comprehend and analyse mean reversion. The standard value throughout a set of data is called the mean. In the case of mean reversion, here the term ‘mean’ denotes the avg. price and reversion stand for reverting. The basic ideology in this approach is that any price that moves from the average for a long time bounds to revert to the norm after a certain period. An SMA can readily depict the norm on a trading chart for an asset. Markets tend to swing about the SMA or simple moving average, attempting to return to it eventually.
Through this conception, several trading methods have emerged; traders through this approach tend to go through a buying or selling process if an asset’s current prices start to differ to a great extent. Although an alteration in returns also indicates the performance of an organisation by which an investor can assume the chances of mean reversion.
How mean reversion tactics can be beneficial?
- By requiring short-term holding
A strategy that emerged from this approach usually requires a trader to hold a position for a relatively small period. Thus these strategies are often preferred by swing traders as swing trading involves a holding period of merely a few days to the maximum for a few weeks. Through this approach thus investors can earn sound profits due to the greater turnover that gives access to multiple opportunities.
- Increases the scope to trade
Since markets tend to stay in trend for no more than one-third of the time, the rest of the period reserves to conditions denoting a range-bound market. Since reversion to the mean methods performs better in range-bound market situations, which prevails over two-thirds of the period, there will be even more possibilities to profit from them than from trend trading scenarios.
- Chances of increasing the avg. win ration
Most techniques have a risk-to-reward ratio that seems to be relatively modest. In common terms, these trading techniques aim for a return of one or one and a half units per unit of risk. It has the effect of increasing the program’s overall winning percentage.
Importance of mean reversion techniques
Certain techniques emerging from this approach tend to benefit financially as an asset’s value reverses to more standard or mean rates. If you’re wondering about utilising a mean reversion method in your trades, make sure that even a price moving away from the average doesn’t always guarantee the price will go down. Instead, it can also happen that the average might go up to reach the price. Since the price has returned to its norm, this will also be considered reverting to the average. Although reversion to the average value is a common occurrence, markets rarely stay right at the average for extended periods. There are several common mean reversion tactics that traders around the world use in different markets include co-integrated portfolio trading and directional trading.
Certain limitations of using mean reversion methods
Sudden spikes or lows may signify a change in the pattern, thus a returning to a usual state isn’t assured. Future product launches or advancements on the bright side, or cancellations and litigation on the bad side, are examples of such situations. Even a drastic circumstance could cause a reversion to the norm in an asset. However, as with the other functionalities of the market, there are never certainties regarding how specific occurrences will impact a specific asset.
Only a range-bound can operate quite well with a mean reversion approach. A price series that has been swinging for a longer period will most likely not perform satisfactorily with this method.