Profit opportunities can be found anywhere in the forex market, including when the price moves back to a normal condition. This is called mean reversion strategy.

This is a trading strategy that is based on the premise that over a certain period, the price of an asset in the forex market will return to its average or mean price after a sudden rise or an extended price movement. In other words, the mean reversion strategy is built on the idea that in the long-term, prices will revert to their previous average prices and normal pattern. The goal of this strategy is to seize profits as soon as the price of an asset reverts to normal levels.

Mean reversion strategy

Different mean reversion trading strategies are available for forex traders to choose from, and some of them are:

The most ideal way to use the mean reversion strategy is to trade price ranges that are seen after a heavy rise or fall in price. Here, reversion to the mean implies that the middle of the range will be the average price and that is where trading should be concentrated around. This strategy tends to produce a higher win rate once extreme changes in price are observed.

 

Identifying the Mean and Reversion

Generally, the mean is the average price over a particular set of data points. On the trading chart of an asset, a Simple Moving Average (SMA) is used to represent the mean. This Simple Moving Average then calculates the average price in the set of prices made available. As time goes on, prices tend to revolve around the average before finally returning to it.

There are different metrics for determining the possible time that the price will revert to the mean and one good example of such metrics is the distance from the SMA. Technical indicators can also be used by traders to inform them of when prices get closer to extreme levels and may revert. Some of the technical indicators used for this purpose include Keltner channels, Bollinger Bands, Envelopes, and regression channels. However, it should be noted that in trading, these indicators can only provide signals and are not necessarily a clear indication of the occurrence of a reversal.

Many times when the mean reversion strategy is used in forex trading, a trader will be getting in and out of trades quite quickly which is why this strategy is best suited to day trading. There are different ways to use this strategy to achieve effective results which include:

  • A break outside the Bollinger Bands strategy with a return to the mean.
  • Testing support and resistance strategy as the price strengthen.
  • Price stretch from the strategy of a Simple Moving Average.

 

The 3 Keys of Mean Reversion Strategy

The mean reversion strategy has three main components namely:

  1. Broad market timing – this enables the trader to have a range of time frames for entering the market.
  2. Entry signal – this informs the trader of the ideal time to enter positions in the market.
  3. Exit signal – this informs the trader of the best time to get out of the market.

These three components allow traders to capitalize on the trading opportunities due to sudden price spikes or movements. The mean reversion strategy is popular with forex traders because it has an effective exit strategy since the average price always serves as the take-profit target. It also gives traders excellent risk-adjusted returns along with a high rate of winning trades; the shorter the mean reversion time frame utilized by the trader, the higher the rate of winning.

 

Mean reversion is an essential component of all financial markets including the forex market. It occurs because prices tend to rise beyond and fall below their intrinsic value. These "abnormalities" in price occur due to the impact of new information hitting the market which takes time before the market adjusts to the information. It will take some time for participants in the market to understand the new information due to the slow rate of filtering while the market itself takes some time before a fair value can be established based on the new information. Also, the rise and fall in prices are due to the collective emotions of the players in the market which is something traders can capitalize on, especially in ranging markets.