6 Common Mistakes Mean Reversion Traders Make

Hi, Adrian here, founder of Enlightened Stock Trading. And in this video, I'm going to cover six common trading mistakes that mean reversion traders frequently make. And these mistakes are absolute killers. They can destroy the profitability of your system and your account if you're not careful. So let's jump straight in. But before we go any further, make sure you hit the subscribe button and give this video a thumbs up so that you get notified of all of my future videos because I've got new trading content coming out all the time and I don't want you to miss a thing. Mistake number one is is trading illiquid instruments. One of the biggest problems with mean reversion trading is that the average profit per trade is very, very small. And what that means is if you get too much slippage, it'll destroy the profitability of your strategy. So how do you avoid getting too much slippage? You make sure you trade highly liquid stocks and ETFs with your mean revision trading strategy. If you try and trade small caps penny stocks in a mean reversion fashion, you're going to get hurt because the slippage is going to be too much and it will probably erode the average, the average profit per trade of your strategy. The only exception to this is if you enter and exit your mean reversion trading strategy using limit orders. If you do that, then you can use slightly lower liquidity levels in your trading. But you still got to be careful because you got to make sure that you don't let your slippage get out of hand. So mistake number one is is to trading illiquid instruments. Mistake number two is not exiting quick enough. What does this mean? Well, in mean reversion, what we're trying to capitalize on is the elastic band we're going to buy when it's oversold, stretched, and then we're selling when it snaps back. Notice that that snap back occurs really, really quickly. And often after the snapback, there can be another collapse in price. So you got to make sure you're reversion trading strategy is nimble. When you buy after a small increase in price or a small move in your favor, you want to get out exits like one profitable close in your favor or two profitable closes in your favor. Or the RSI two popping up to a value of 30 or 40 really, really quick nimble exits because that'll get you out with the bulk of the profit and it gets you out of harm's way because often with mean reversion after the bounce, there can be another collapse, because sometimes that initial oversold is the start of a new downtrend. If you don't get out quickly, you're going to get whacked by that downtrend as it progresses. So the second big mistake in mean reversion is not exiting quickly enough. The third mistake is using tight stop losses. Now, tight stop losses are a real problem with mean reversion trading, because mean reversion relies on a high win rate in order to give you positive expectancy. You get lots of small wins and the occasional large loss. You might have 9.1R gains and you might have 1.5 or 6R loss. So the gains are much smaller than the loss. Now, if you use a tight stop loss, what happens is some of those small gains will turn into losses because often they move against you before they bounce. If you've got a tight stop loss, when your trade moves against you, the stop loss is going to take you out, lock in that loss, and then you've missed the bounce, which happens a day or two later. So tight stop losses are a real problem for mean reversion trading strategies. If you want to get around this, then I'd suggest you have a look at using much wider stop losses, or, heaven forbid, no stop loss at all. Be careful with that one though, because that can bite you in the ass as well. But a wide stop loss might be something like 20 or 30 or 40% on a fairly volatile stock. So use wider stop losses and avoid this problem of your win rate dropping and your expectancy falling apart. The next big common mistake that mean reversion traders make is hold and hope. Now, most traders don't like to have large losses. And when you're faced with a mean reversion trade that's going against you, the natural inclination is just to hold on and hope that it turns around and bounces back in your favor. Now, the problem with this is if it doesn't and it keeps going, you're going to end up with a massive loss. And with mean reversion, all of those small, tiny little gains are not going to add up to enough to compensate for that massive loss that you've just incurred. Hold and hope in mean reversion is one of the most dangerous things you can do. If you get an exit signal and it's a loss, get out of the trade, move on to the next one, keep those losses contained. If you let them get out of control, the expectancy of the system will fall apart. You'll end up with a massive drawdown and a huge Financial headache, hold and hope not a strategy. The next mistake is using leverage and large position size in your mean reversion trading strategies. Now, the problem with leverage and large position sizes is in the backtest. When you test your strategy, they tend to using leverage and large position size tends to make a lot more money. It shows you this huge equity curve with really, you know, rapid growth, higher, you know, high compound annual return, and it's really, really appealing. But the trouble is the more leverage you use and the larger your position size, the higher your risk of ruin. And risk of ruin is something that the backtest often doesn't really show. It doesn't really pay. Give it full justice or full it doesn't really illustrate the true risk that you're taking on. So if you take on leverage and you use large position sizes, what can happen is when you get one of those large losing trades, you know you've got small win, small win, small win, small win, large loss, which are common for mean reversion. That large loss, if it's bigger than expected, it could wipe you out. If you're using leverage or a large position size, I prefer to use 20 or 15 or 20 positions per system for mean reversion and make sure each of those are small. And I don't use leverage on mean reversion. The reason is I just don't want to get wiped out. And if you want to stay in the game and avoid massive drawdowns, then using leverage and large position sizes in mean reversion is something you want to avoid. The next common mistake that traders make with mean reversion is sloppy order entry and or using the wrong order type. Now, with mean reversion, I've already said that the average profit per trade is very, very small. So you've got to make sure you don't incur too much slippage. If you're trading super high liquidity stocks or ETFs, this won't matter that much. You can use market orders to enter and exit, but if you're trading anything else, using limit orders is a much better way to do it. And if possible, you want to participate in the opening price match. If you're placing your order after hours and you know when the market first opens, the buyers and sellers that are in the market lined up with their limit orders, they match up at the official opening price and then normal trading commences. What I like to do is get my limit orders, sorry, get my mean reversion trades executed in that opening price match because then there's no slippage and I don't miss the opening price. That's for a system that enters at the open for a system that enters on limits, as in, you know, let's say it's over, the stocks oversold and we place a limit order for the next day further down. So if it keeps selling down, that limit order gets triggered, then there's no slippage for that sort of order because it's a limit order. So using just a straight market order can be a bit of a problem, particularly on lower liquidity stocks. I'd encourage you to think about using limit orders because you'll get much better, much better fills, much better price. You may not get filled every time, but you're not going to get the slippage. It's not going to kill your account. So those are some of the most common trading mistakes that mean reversion traders make. If you can avoid those mistakes and follow a profitable mean reversion trading system, your chances of success are astronomically higher. So make sure you avoid the most common mean reversion trading mistakes. In the next video, I'm going to talk about the best indicators for mean reversion trading. So click watch that one or scroll further down the article if you're on the website and I'll see you in the next video. Bye for now.