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What is reversion to the mean in trading?

As traders might know, there are many different ways that one could trade the forex markets. The most common approaches include trend trending. Trend trading is where, you are basically following the trend. This is a common approach as it is often considered safe. You are after all positioned in the general direction of the trend.

Besides trend trading, there is also the counter trend trending. As the name suggests, counter trend trading is where you take an opposition position to the trend. This means that you are basically trading the corrections that occur within the trend.

Counter trend trading is not suited for all as it requires quite a bit of experience and some decent understanding of how the markets work. Then, we have the famous breakout trading. Breakout trading is when prices consolidate into a sideways range. Here, following a brief consolidation spell, price breaks out strongly from the range and establishes a new trend or continues in the direction of the previous trend.

Break out trading can be risk as many a times, traders will be trapped based on weak position or false breakouts.

Besides these mentioned methods of trading, there is another method of trading called the reversion to the mean or the mean reversion trading.

What is mean reversion?

Mean reversion is a concept that is valid both in trading and draws from match. According to mean reversion, when price moves to an extreme level, it often snaps back to its average or the mean.

This can be commonly found across various instruments and not just the forex markets. When the price of any security moves adversely away from its mean price, it tends to revert back every now and then.

But the trick is that sometimes prices can continue to remain at the extreme levels as prolonged periods of time. To be able to trade the mean reversion method, traders need to get their timing right.

If you do get everything right, the rewards can often be great. This is because, you are firstly positioned early on into the trade. This allows you more wiggle room and also greatly increases the profits that you are able to make.

How to trade using mean reversion?

Firstly, mean reversion trading is not a short term trading strategy. This means that you will need to be aware of the trends and monitor the longer term chart. When price tends to move in a parabolic fashion, you will see that after a certain point, prices revert to their mean prices.

There are a number of ways to trade this. Firstly, and the most obvious is to trade the extremes. But this requires a lot of patience and confidence as prices do not snap back right after moving to an extreme level.

You can however make use of some indicators that can help you to take advantage of this. Example of the indicators belong to the price band or channel indicators. This means that you can trade mean reversion using Bollinger bands, Moving average envelopes to name a few.

In these methods, you will merely be taking a short or a long position depending on when price action is at the extreme levels, and of course taking into account the overall trend as well.

01 Mean Reversion

Example of mean reversion using Bollinger bands

In the above chart, we can illustrate how the mean reversion works by taking the example of the Bollinger bands indicator. You can see that in the above chart, we have two instances. Firstly, prices make a strong decline and move to the outer extremes of the Bollinger bands.

Following this, we then see price making a reversal and then heading back to the mean, or the 20-period moving average of the Bollinger band indicator.

Similarly, we can see another example where price then moves to the outer extreme and then snaps back. This once again leads to prices moving back to the 20-period moving average line. These two instances are nothing but reversion to the mean.

But as you might have notice, the mean reversion is not that simple. In the above case, price action quickly snapped back to the mean or the moving average rather quickly. But in some cases, you will see that prices continue to drift at the extremes for prolonged periods of time.

How to improve mean reversion trading?

There are a number of ways that one could use to improve their timing when it comes to trading with mean reversion. The first is by looking at the higher chart time frames than the one you are trading on. These higher chart time frames can potentially predict based on the candlestick patterns whether price will snap back to their mean or not.

Using oscillators, you can do the same as well, as they indicate the potential overbought and oversold levels.

The mean reversion trading is not that commonly found, but perhaps that is the reason why this type of trading can give you better results compare to the more widely known forms of trading.

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