What is mean reversion trading and why is it so popular?

Implementing a trading strategy isn’t easy, as you have to find one that fits your trading personality, risk appetite, and goals - not to mention that there are so many different market approaches you can adopt.

Have you, for instance, ever noticed how prices tend to come back to average levels after extreme price moves?

If you’re using technical analysis in your trading, then you know that markets always move in trends (upwards, downwards, neutral). Depending on market psychology, trends have different phases, and prices can sometimes be quite volatile and extreme.

There is a certain theory that relies on the fact that prices that move away from their average tend to return to their mean price over and over again - a phenomenon called “mean reversion”.

Let’s discover mean reversion trading in this article.

What is mean reversion in trading?

Mean reversion is a theory in finance suggesting that an asset will return to long term average levels, meaning that extreme price fluctuations are rarely able to last and are often followed by a move in the direction of the mean.

Mean trading is, therefore, a trading tactic that aims at capitalizing on extreme price moves by assuming that the given asset will revert to a previous state (to mean levels).

To spot assets that will likely return to the average, traders and investors often focus on those that have recently registered performances that differ from their historical mean prices.

The goal is to find out assets with abnormal trading activity that might soon revert back to normal patterns.

Does a mean trading strategy work?

Some critics of mean trading believe that this strategy cannot work because markets are efficient and all relevant available information is already priced in, which means that there is little chance to be able to beat the market without insider trading.

Still, mean reversion is a strong notion that traders can use to build strategies with a trading edge, because market participants have a tendency to under and over-evaluate financial assets - and you can take advantage of these imbalances!

What are the most popular trading tools used for mean reversion trading?

There are a range of different trading strategies that can be used in mean reversion trading.

Most of the time, this technique relies on trading tools that will help traders spot extreme price situations so they can buy when an asset quickly drops, or sell an asset when it rises quickly.

Among the most popular technical indicators, traders often use moving averages, standard deviation, Bollinger Bands, Donchian channels, Keltner channels, Relative Strength Index (RSI), Ichimoku cloud, regression channels or lines, money flow, and MACD.

Market sentiment indicators are also popular for measuring the level of activity and volatility that can trigger potential mean reversion movements, such as trading volumes, VIX, Commitment of Traders (COT), high/low index, and put/call ratio, among others.

Final word

Mean trading strategies are quite popular, because they’re often easy to use for catching an imbalance in the market, either because of a significant sell/buy order without obvious reasons justifying this move, or because of a market overreaction to short-term and often unexpected events.

However, trading psychology isn’t always easy to manage with mean trading, especially because you’re often trading against the herd.

To develop a sound and reliable mean trading strategy, you will need market conditions to remain relatively stable over time, while taking advantage of illogical and unfounded reactions over the short to medium-term.

You should also always have a written trading plan with clear entry/exit signals and sound risk and money management rules to follow to be a more disciplined, responsible, and effective trader.

If you want to discover more trading strategies to use in the Trading Cup live trading contest, have a look at our dedicated articles - What instruments can I trade and what trading strategies can I use? And 10 Strategies You Can Copy off Past Trading Cup Qualifiers.

Trading Cup // Education