Day traders make money by successfully predicting price changes. This is true when trading commodity futures, foreign currencies, and stocks. Prices go up and prices go down. This happens with long term trends and it happens within such trends. One useful approach is called the mean reversion strategy. What is the mean reversion strategy? It is an approach to trading that relies on the tendency of stocks, commodity futures, or currencies to revert to their mean or historical average price.

Definition of Mean Reversion Strategy

Stock, currency, and commodity future prices very commonly follow channels. These channels are defined at the top price by a resistance level and at the bottom by a support level. Barring fundamental changes, trading generally takes place within the channel. When prices go up they tend, eventually, to come back down and vice versa. A mean reversion strategy works on the assumption that what goes up will come down and what goes down will come back up.

Advantages and Disadvantages of the Mean Reversion Strategy

There are several advantages of a mean reversion strategy. It is a systematic approach to day trading and thus provides a structured way to identify entry and exit points. It is versatile in that it can be applied to various time frames and types of underlying assets. This approach lends itself to risk management via take-profit and stop-loss levels. A mean reversion approach does not work well when a market is trending up or down very strongly based on changing fundamentals. It can also be a costly strategy as it typically means placing lots of trades for small profits.

How Does the Mean Reversion Strategy Work?

A stable company with a stock that trades within a predictable channel is a common target for a mean reversion strategy. The stock will tend to rise in anticipation of earnings reports, for example, and then fall back between these reports. A trader can assess the likelihood of this behavior continuing and place trades that profit by both high and low prices within the channel reverting to the mean. This approach is generally profitable so long as the company is not subject to fundamental changes which drive the stock price up or down and out of its typical trading range.

Common Examples of Mean Reversion Strategies

A common mean reversion strategy is to use the RSI or relative strength index. This technical indicator indicates both overbought and oversold situations. Overbought situations generally occur with high stock prices and oversold situations occur with low stock prices. This indicator is therefore useful in telling a trader when a stock is trading above or below its average price. Another useful tool that is commonly used for a mean reversion approach is the MACD or moving average convergence divergence indicator.

Building a Mean Reversion Trading System

Some commodity futures, currency pairs, or stocks lend themselves to success with a mean reversion strategy. Others do not. Likewise, underlying assets that trade in a predictable channel generally lend themselves to profits with a mean reversion approach while assets in strong trends often do not. Thus, picking the right commodity future, currency pair, or stock is important in setting up a reversion trading system. Then it is important define how one enters, manages, and exits trades in a disciplined manner.

Risk Management for Mean Reversion Strategies

The first way to manage risk with a mean reversion strategy is to pick an appropriate commodity on which to trade futures, an appropriate currency pair, or an appropriate stock. It is useful to backtest a mean reversion approach on such an asset. When actually trading it is essential to set stop-loss and take-profit levels with each trade. This is not a strategy that leads to extravagant profits. Rather it is one that generates repeated small profits. As such a trader needs to limit their risk with every trade and stick to predictable trading situations exercising discipline with every trade.