Futures Trading Strategies: What Is Mean Reversion Trading?
When you tug on rubber bands or stretch them, they immediately snap back. There’s a trading strategy based on the financial notion that works in a similar way, which is mean reversion trading.
The pendulum is another metaphor to help you comprehend this idea. It appears to constantly make its way back to the center even after swinging first to the left and then the right. Although the idea is simple, putting it into practice in the futures market calls for discipline, a sharp eye, and sophisticated trade management abilities, particularly if it fails.
Understanding Mean Reversion Trading
Mean reversion trading, as the name implies, is based on the notion that asset prices have a “mean” or average level that they typically return to. Put differently, in the event that prices diverge much from their “mean” or average price, they usually return to their historical norm. Traders profit from this by purchasing or selling in order to capture the return to its average value.
Significance of Mean Reversion Trading
In the realm of trading, there is a saying that goes, “Markets climb the stairs but fall down the elevator.” This basically sums up how quickly prices may decrease in contrast to how slowly they can increase. Additionally, this dynamic is pure gold for mean reversion traders, offering profitable trading opportunities. Even while it’s incredibly popular, not everyone enjoys following trends.
It is important for traders to choose a strategy that fits their cognitive style and temperament. The fast-paced nature of reversal trading may be a welcome diversion for those who become restless on the plodding ascents of trending markets. But mean reversion isn’t something that should be done lightly. This approach may be difficult for you if market volatility makes your heart race or if you tend to make snap trading judgments. Reversals are characterized by high velocity and volatility and can be erratic. Thus, like with anything in trading, be aware of your limitations before taking a risk.
What Are Mean Reversion’s Principal Features?
These mean reversion principal features should be taken into account before entering the market in hopes of making a rapid top or bottom fade.
- Asset Conditions: One way to assess an asset’s condition is to see if it has reached an overbought or oversold area. In that case, how are you verifying that assessment?
- Volatility’s Role: How erratic was the swing to the far side of that overbought or oversold area? In the event that volatility is absent, there is a chance that the price may spike against your position, and a massive loss might result from it.
- Reversion Phase: Are you trading a correction inside a broader trend, a reversion within a broad trading range (sideways market), or a trend reversal? If you have to manage your trade or quickly quit, you should be able to predict where and when prices could invert against you.
Mean Reversion Trading Strategies and Indicators
Moving Average Convergence Divergence (MACD)
Although it has a lot of false signals, the MACD can be useful in identifying divergences. To prevent this, focus on the whole price context and only place a trade after confirmation, which is often a breakthrough from support or resistance in the pattern.
We saw a divergence between the MACD shape across several candles in the case above. Nevertheless, the MACD is infamous for providing false divergence signals, therefore this is insufficient to indicate a short trade. Thus, we only await confirmation. A price breach below the latest swing low indicated that it was time to short the market. While some traders believed that the swing low would have provided support, the MACD divergence entered the picture.
Bollinger Bands
Usually set to two standard deviations, this indicator is composed of a central band and two outer bands. Prices have a tendency to return to the average-represented middle band when they touch or move outside of these bands, which may suggest overbought or oversold circumstances, respectively.
The aforementioned example demonstrates precisely what Bollinger Bands are intended to represent. Prices surged higher in this instance, closing over the top band many times. Taking into account that two standard deviations are represented by the upper band. There is a good likelihood of a correction. However, we are unable to forecast the extent of the correction.
Right after the peak swing point, on the downward candle, would have been a fantastic trade setup. The best strategy to fade this market would have been to take a short position with a stop loss above the highest high upon the breakout of that candle. As you can see, the next candle’s price gradually moved back to the moving average.
Relative Strength Index (RSI)
The pace and variation of price changes are measured by this momentum oscillator. If the RSI is above 30, it indicates oversold conditions; if it is over 70, it shows overbought situations. Examine the chart that follows:
The RSI’s oversold signal provided an ideal entry time for taking advantage of the rise. You’ll see that after the decline, the purchase signal was a breakout of the smaller congestion region. The lowest swing low point would have been the location of the stop loss.
Stochastic Oscillator
This measure contrasts an asset’s closing price with a range of its prices over a specified time frame. It can assist in determining overbought and oversold situations, just as the RSI. The following example demonstrates a fast scalp with stochastics.
Prices were continuing to rise for many candles, but they were now in overbought territory. What made a trend line and bided their time till prices dropped below it. Luckily, the stochastic reading also declined at the same time as the trendline break. We would have withdrawn from the short trade as soon as the price recovered from the oversold area.
Risk Management In Mean Reversion Trading
Since no plan is ever guaranteed to work 100%, risk management is crucial. You may avoid losses and stay in the game by managing risk well.
In this context, recognizing false reversions is one method of risk management. A price may appear to be returning to its mean, but it may instead continue its trend, which is known as a false reversion. To prevent losses, it’s critical to identify and stay away from these misleading signals. Remember, your stop loss is there to protect you when you can’t.
Another strategy for risk management is to suitably size your investments. Never put too much money at risk in one trade. Determine how much danger is appropriate, and don’t take on any more.
Psychological Challenges of Mean Reversion Trading
Don’t allow a couple of victories get to you. You are not unbeatable just because you had a few home runs. Remain grounded and faithful to your strategy of action.
Moreover, consider playing the waiting game just like you do with fishing. The large fish may take a while to bite. Give it some time; in this situation, patience may be your greatest ally. A transaction cannot be compelled. You must bide your time. Better to learn to be patient, right?
Lastly, traders are prone to biases such as confirmation bias, which occurs when individuals disregard contradicting facts in favor of information that supports their ideas.
Conclusion
The main goal of mean reversion trading is to profit from either an excessive price move’s pullback. You need to be quite knowledgeable in order to perform it successfully.
For such an approach to be effective, you need the appropriate abilities and mentality. Thus, constantly stay alert, take lessons from every transaction, and be prepared to adjust your strategy when necessary.
