Mean Reversion Trading – Profiting from Price Returning to the Average

What is Mean Reversion Trading?

 

 

Mean reversion trading is a strategy based on the concept that asset prices tend to revert to their historical average or fair value after periods of extreme movement. The idea is that when an asset's price deviates significantly from its mean, it is likely to return to that average over time.

 

 

This strategy is commonly used in stocks, forex, and cryptocurrencies, particularly in assets that show cyclical price patterns or well-defined ranges.

 

 

How Mean Reversion Trading Works

 

 

1. Identify an Overextended Price Move

 

 

- Look for assets that have moved significantly above or below their historical average.

 

 

- Use technical indicators such as:

 

 

- Bollinger Bands: Prices moving outside the upper or lower bands indicate potential mean reversion.

 

 

- Moving Averages: An asset significantly above or below its 50-day or 200-day moving average may be overextended.

 

 

- RSI (Relative Strength Index): Readings above 70 suggest an asset is overbought, while readings below 30 suggest it is oversold.

 

 

2. Look for Reversal Signals

 

 

- Once an asset has deviated far from its mean, traders look for signs of exhaustion or a slowdown in momentum.

 

 

- Common signals include:

 

 

- Divergence in MACD or RSI, suggesting weakening momentum.

 

 

- Candlestick patterns, such as dojis or engulfing patterns, which indicate potential reversals.

 

 

3.

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