As you may know, the technical trader is more concerned with strategies and the implementation of complex mathematical models. Using these strategies along with the trading technology, you can say that they blend well with algo-trading. So, the mean reversion trading strategy is a stimulating strategy.
Trading is a hot topic among traders as the trend continues. Trend trading is a style of trading where a trader gains from the analysis of an asset’s momentum in a particular direction.
So when the uptrend is identified with lots of highs and lows, this seeks out the opportunities for traders to enter into a short position, and when an asset is trending lower, the downtrend is identified by the lower swings and the higher swings.
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What Is the Mean Revision?
A mean reversion strategy is a trading strategy in which prices tend to return to the average levels of the stocks. In this trading pattern, the prices seem to move hard and sustain for an extended period of time. A trader who employs these strategies must frequently develop numerous methods for employing the manoeuvre. So, in all cases, there is no pure guarantee of returns as the volatility, price, and other factors in trading affect the mean reversion indicator.
In the financial world, the mean reversion theory states that the security prices and economic indicators of an asset tend to revert to the historical mean of an asset. You can take a simple example of TCS software in the early 20s when the stock price went down, and people bought stock for the long term in expectation of stock value to surge in the future.
This mean reversion principle can be applied using the fundamental factors of trading, which is buying a stock with a low Profit-Earnings (PE) ratio and expecting the PE to rise to the historic average PE. Traders often follow this strategy to buy securities for long-term investments. A trader who uses these strategies often needs to develop many methods for using the mean revision.
Mean reversion strategies attempt to gain profits from the price of assets that return to normal levels or the average. So, while considering a mean reversion strategy, you need to consider historical data. This historical data doesn’t mean that the asset price will fall or rise. The mean of the financial asset can also go up in line with its average. Considering the mean, it is rare for prices to remain exactly as the mean for an extended period of time.
Mean Reversion Formula
To further understand the mean reversion and its calculation, you need to know the formula of the mean reversion trading strategy. The mean is the average price over a given number of data points.
Consider assets, such as Reliance Industries, where the mean is represented in the chart by a simple moving average (SMA). The SMA calculates the average price of the following assets. You can consider the SMA with respect to time, which eventually returns to it.
Traders use various metrics, and the SMA is used to help establish prices that could revert back to the mean. You can also use technical indicators such as Bollinger bands, regression channels, and so on, each with its own formula, to alert traders when the price is approaching extreme levels and is likely to revert. But be cautious; these indicators do not always guarantee the reversal of the stock price.
The following chart of Reliance Industries’ stock shows the 50-day SMA over a one-year period. You can also apply the same concept to different time intervals, including short-term trades.
You can use this mean average strategy on various instruments through the Share India app. You can also practice trading with a demo account at Share India. There are multiple strategies that you can use in the Share India trading platform.
Some Popular Types of Mean Reversion Strategies
- Mean reversion in pairs: The pair trading involves finding two highly related assets. The price of these assets tends to move in a similar manner. In simple words, if one asset price drops and another asset doesn’t, then there is a potential chance of a reversion trade. It is also referred to as statistical arbitrage. A pair trade requires buying and selling an underperforming pair of stocks at the same time. It is a trading strategy in which you must invest in both assets regardless of individual movement.
- Directional Trading: In directional trading, each instrument’s movement is independent of one other financial instrument. Consider an example of palm oil company stocks that were trading at ₹50. Due to a shortage of palm oil in the global market, the stock price seems to surge by ₹80. However, according to the mean reversion principle, the price of palm oil stock will return to the average change, and the stock price will remain the same or close to the average.
There is also intraday mean reversion, where the strategy works when a strong trend is present, combined with the moving average. In this strategy, the price of a financial asset goes near the line and then moves in the trending direction. Intraday means reversion only works when there is a strong trend. Trading in the same direction as the trend is referred to as momentum trading.
Limitation of Mean Revision
The first and foremost limitation of this strategy is that there are no guarantees for the stock price to return to its normal pattern. But as with the unexpected ups and downs, it could indicate a shift in the normal range of stock prices. The price of a stock in the stock market may fall or rise depending on an external effect or other factor, such as a case of loss in business.
Conclusion
A mean reversion trading strategy offers stock traders the opportunity to buy at a lower price and sell at a higher price. A mean reversion works for the long term and in an uptrend. You can use this mean reversion strategy for individual stocks and for more trading opportunities by joining Share India’s trading platform. It offers lots of tools and indicators to make your trade easier and advance in terms of technology. Price is an unstable variable, so you need to track the historical data and make your trading decision. You can also automate this trade with a stop-loss to execute it whenever the stock price reaches the average.
Frequently Asked Questions (FAQs)
What is the function of stop-loss?
A stop-loss is a tool used to execute trades at a predetermined price that the trader sets. The trader can sell or buy financial assets at their stated price.
Can you select stock pairs?
To select stock pairs, you need to segregate stocks on the basis of market capitalisation, sector, traded volume, liquidity, etc. Depending upon the variable and goal, you can select the stock pair.
What is meant by holding?
The term holding refers to the act of holding a financial asset or position for a desired time period. This time interval depends on your trading.
