An Introduction To Mean Reversion Trading And The 4 Biggest Challenges

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An Introduction To Mean Reversion Trading And The 4 Biggest Challenges

Mean reversion trading is often referred to as counter-trend or reversal trading which all, more or less, describe the same type of trading style. A mean reversion trader looks for price that has moved away significantly from its mean (average) price; the mean reversion trader looks for unsustainable trends.

Although most people prefer the trend-following approach, I never felt comfortable with the general trend-trading mindset and I started looking at mean reversion trading very early on. Needless to say, I got burned a few times in the beginning since this trading style is not suited for absolute beginners due to the emotional and psychological challenges it poses on the trader. In the following article, we take a look at mean reversion trading, what the most overlooked aspects are and which challenges a mean reversion trader has to deal with.

 

 

 

Mean reversion trading – a brief introduction

As said above, a mean reversion trader is looking for opportunities where price has moved away from its mean (or average) price significantly. Usually, the mean price is calculated by using a moving average and applying it to the charts. For example, the chart below shows the EUR/USD Daily chart and a 50 period smoothed moving average.

As you can see, price frequently pulls away from the blue moving average and then snaps right back to it. If this sounds too good to be true, it is. Of course, those hindsight-charts with the perfect trades only tell half of the story.

 

mean_reversion_1

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The screenshot below shows the same EUR/USD Daily timeframe with the same moving average.  But this time, I marked all the pullbacks that did not make it all the way to the moving average. And, of course, if we’d look closer, there would be many more times when price attempted a reversion, but it failed. Therefore, mean reversion trading is more than just trading back to the moving average and it requires a very strict entry management, risk management approach and an emotionally stable character to avoid things such as revenge-trading or over-trading.

 

mean_reversion_2

click to enlarge

 

The 4 main challenges of mean reversion trading

In the following, we take a look at the most commonly overlooked aspects that make mean reversion trading harder than it seems at first glance.

 

#1 How do you determine the mean?  

Although this seems very obvious, most traders never think about the implications their choice of the moving average has on their trading. Let’s take another look at the EUR/USD chart from above. This time we applied two different moving averages: the 100 smoothed moving average (SMA) in red and the 50 SMA in blue. The differences may seem insignificant, but for a mean reversion trader, choosing the correct moving average is one of the most important decisions and it also is a very personal and individual one. These are the main differences between the two types of moving averages:

 

Faster moving average (50 SMA)Slower moving average (100 SMA)
Price can pull away from the moving average faster and more often.Price does not pull away from the slow moving average often and it takes longer.
Generally more trading opportunities.Fewer trading opportunities.
Price may trade back to the fast moving average in a shorter period of time.A reversion may not always reach the moving average that easily.
Trades are shorter in distance and may have a smaller reward:risk ratioThe reward:risk ratio can be higher after strong trending phases.
More trades and smaller trades.Fewer trades, but better reward:risk ratio

 

As you can see, this is not judgmental and there is no right or wrong when it comes to choosing a moving average for your trading. Instead, I want to highlight the fact that the choice of the moving average has wide-ranging consequences on your trading style and it has to be made based on personal preferences and character styles.

 

mean_reversion_movingaverage

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#2  Sometimes price does not reverse, but the moving average catches up with price

The second most overlooked and undervalued aspect is that sometimes the reversal happens very slowly and in the meantime, the moving average moves closer towards price and, thus, reduces the reward:ratio of the trade.

The screenshot below illustrates the point. Although, at first glance, it looks like the mean reversion strategy works like a charm and price always comes back to the moving average,  it is important to understand that sometimes, the moving average catches up with price faster and can reduce the initial reward:risk ratio and consequently the expectancy of such a trading strategy. A trader then has to decide if he leaves his initial take profit order unchanged or if he moves his take profit along with the moving average.

 

mean_reversion_movingaverage2

click to enlarge

 

#3 Mean reversion vs. catching a falling knife

Picking tops and bottoms can be a very dangerous thing to do in trading and amateur traders, especially, often engage in such trading behavior because they underestimate the fact that price can keep on trending much longer than they think.  During periods of long-lasting and strong trends,trading mean reversion can often lead to significant losing streaks without taking precautions. The screenshot below shows the current EUR/USD Daily chart and it took price about 300 trading days to eventually meet up again with the moving average.

 

mean_reversion_knife

click to enlarge

 

A mean reversion trader is not waiting with pending orders at predetermined levels, as standing in front of an approaching train, but rather waiting until the train has come to a stillstand and offers clues that it’s going the other way.

 

#4 Emotional stability and discipline

Although this is true for all types of trading, it is especially important for mean reversion traders. It can take very long until a trading signal occurs and very often you will not see all your entry criteria, but still price goes back to the moving average. Staying away from jumping in late and not trying to chase a trade is very important. Other times, all your criteria line up, but price still keeps on going against you. Not cutting your loss and adding to a loser is what mean reversion traders often do because they believe that the reversal is overdue.

Tip: Oscillators, such as the STOCHASTIC, often provide the wrong implications for mean reversion traders. Overbought and oversold scenarios are often used as reasons to enter counter-trend trades, whereas overbought prices often just signal a very strong trend – not an overdue reversal.

 

All these points highlight the complexity and the challenges for mean reversion trading and it becomes obvious why this style may not be suited for amateur traders, or traders who are still struggling with the mental aspect of trading. However, not all traders feel comfortable trading with a trend following strategy; it is therefore important that you audit yourself to find your perfect fit.

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