Advantages and Disadvantages Of Mean Reversion Trading

In this video, I want to share with you the advantages and disadvantages of mean reversion trading strategies. 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. This is really important because every trading strategy has different trade offs, different advantages and disadvantages. And if you're going to trade mean reversion effectively, you need to understand this and make sure that it is a strategy that you can do both psychologically and also practically. So what are the advantages and disadvantages of mean reversion trading strategies? Let's have a look. Okay. Advantages first. First one is mean reversion trading gives you a very high win rate. Now this is really important if you like a lot of positive feedback in your trading. One of the challenges about trading in general is that we get a lot of negative feedback and we just, you know, it can be quite psychologically difficult.

But one of the best things about mean reversion trading is that it's a high win rate strategy, which means you can be right 70, 80, even 90% of the time. So you're constantly getting positive feedback on your trading. Doesn't mean it makes, you know, astronomical returns just because you're right 80% of the time, but it does give you that positive feedback. The next advantage of.

The next advantage of mean reversion trading is low exposure. Now, low exposure is really powerful because.

You'Re able to generate profits with mean reversion without having a lot of your money in the market.

All the time. So I have a mean reversion strategy, for example, which only has an average exposure rate of about 5%, which means your money is invested 5% of the time on average. Now if you think about that, if you can make decent returns with a very low exposure, that means you've got a lower exposure to your to catastrophic market moves, to changes in market trend, to sudden shocks to the market because your system isn't in the market all the time. So mean reversion has a low exposure, which is really, really helpful.

The next thing that is an advantage of mean reversion over many other trading strategies is the smooth equity curve. And this is directly related to the high win rate of the systems. Mean reversion tends to because it's highly accurate high win rate.

You find the equity curve has very smooth moves up, punctuated by the occasional large loss and Then smooth moves up. So if you stand back and look at the equity curve, it does tend to be a nice smooth loss line compared to trend following which is a bit more of a, can be a bit more of a wild ride if you like. So smooth equity curve, really good advantage of mean reversion trading. The next one is short hold time. Now mean reversion is great for people who like a bit of action, who don't want to hold on for too long and don't want to wait too long for their for confirmation whether the trade was a winner or a loser. Average duration for a mean reversion system on a daily chart could be one day, could be several days, maybe up to five days. But it's generally not much more than that because the move that we're trying to catch is a short sharp bounce after a correct, a sudden move against the trend. And those happen quickly. We don't want to hold on too long and that means we get a, you know, quick feedback about whether that trade was a winner or a loser. So that can be really positive as well. The next benefit of mean or advantage of mean reversion trading is there's lots of activity. You, you can be entering and exiting trades all of the time and this is really great, particularly if you, if you're an action seeking sort of person. If you like a lot of activity and a lot of trades to keep you interested, then mean reversion trading is, is a really powerful way to, to make money in the markets. Now what are the disadvantages? Well, the first one is there's lots of activity and I've got this in the advantages and the disadvantages column. One of the things that you've got to do in your own trading is find strategies that fit your personality, your objectives and your lifestyle. So for me, I'm a fairly.

Laid back sort of person. I don't want a huge amount of activity. I don't want to take hundreds of trades every day. So when I was trading manually that was a real, the level of activity was a real disadvantage for mean reversion. For me I much preferred long hold times. Buy now, sell several months later after capturing a major trend. That's what I sort of naturally preferred. Now that my trading is automated, it doesn't matter quite so much. It's not as much of a disadvantage from my perspective, but it really can be for you. If you're trading manually, you've got to make sure that you match the level of activity with your natural sort of inclination and also what you can fit in with your lifestyle.

The second disadvantage is small average profit per trade. Now, average profit per trade is across all trades in your backtest, the difference between the entry price and the exit price. Now, in mean reversion, you're going to have lots of small wins and the occasional large loss. And on average, it's going to be profitable, hopefully, assuming you've designed your system well. But the average profit per trade for mean reversion is typically pretty small. And that's okay as long as you've got very highly liquid instruments and as long as you're very careful with your execution. But you've got to be cautious because if you're paying too much in commission or if you're getting too much slippage on your orders, it can really erode the profitability of the system. If you're making mistakes in your execution, if you're not getting your trades in on time, it can really erode the performance of the system to the extent that it could even be loss making. So the small average profit per trade means for mean reversion, you've got to have a very high attention to detail and be very precise, otherwise it can end up hurting you.

So I guess closely related to the small average profit per trade is that low margin for error. Contrast that with trend following. With trend following. When you've got maybe a 20, 30, 40, 50% average profit per trade because you've got some monster winners, it's got a very high margin for error. If you make a mistake or two here or there, it's not going to hurt you. But with mean reversion, the average profit per trade is really, really small. If you make a mistake, it can really hurt the system. So you know what is the mistake? Well, for example, if you held onto a losing trade that kept moving against you and you should have got out of it, that could end up being a much larger loss than you expect. That could wipe out the profits of the mean reversion strategy. So you've got to make sure that you execute it faithfully, exactly as designed, Otherwise you can end up in a world of hurt.

And I just mentioned the occasional large losses. With mean reversion, the profile is small wins and the occasional large loss. So you get lots of small wins. The occasional large loss sounds good, looks great on paper in back testing when you design the system. But if that reality of that large loss is going to be psychologically difficult for you, then that can be a real problem. I don't particularly enjoy wondering whether this trade is going to be a 5r 7r loss move against me hoping for a little 1r gain like that Risk return profile is not natural to me. I'm more naturally a trend follower. I like to risk small amounts and have lots of small losses in exchange for the occasional very large win. So you've got to be aware in mean reversion you are going to get the occasional large loss. They do come suddenly and you've got to make sure you manage your exits to keep that large loss contained. So follow your rules exactly. Otherwise that large loss will get out of hand and will wipe out the system.

The last disadvantage of mean reversion I'm going to talk about today is just that it feels like catching a falling knife. You know, sometimes, you know, you got. Hopefully you've heard this straight this. I'm the same, right? If you hold a knife with the blade down and you drop it and you try and catch it with the other hand, you know that's quite dangerous because if the knife keeps falling, it can slice you and cut you on the way through. It's exactly what mean reversion is like. We're trying to buy on a dip and hope that it bounces and if it keeps dipping, then that can be, that can be dangerous. That's where the occasional large loss comes from. But the psychological impact of that is we're buying on a decline and it's we're buying at the point of maximum fear. And if that maximum fear follows through and keeps magnifying and magnifying, then we're going to end up with a loss that could hurt. So psychologically that is a little bit difficult. Personally, I find buying in the direction of the trend psychologically a little more easy.

Mean reversion feels like catching a falling knife. That's the main disadvantage.

So they're the advantages and disadvantages of mean reversion trading. In the next video, what I'm going to do is go through some of the most common mistakes that people make when it comes to mean reversion. So either click watch that next video now or scroll further down this article and check out the biggest mistakes, most common mistakes that mean reversion traders make. That's all for this video. See you in the next one. Bye for now. It.