Best Mean Reversion Indicators

Hi Adrian here, founder of Enlightened Stock Trading. And in this video I'm going to share with you some of the best mean reversion indicators that you can use for your mean reversion trading strategies. So let's jump in and have a look at what are some of the best indicators for your mean reversion 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. Here we go. I've got a chart of the S&P 500 and this is a daily chart. And what I'm going to do is talk through the indicators one and at a time. I've got five I want to share with you and let's get right into it. So the first indicator of course is the RSI relative strength index. You can see down the bottom here I've got an RSI3 plotted on the chart. So it's a three period RSI. And what RSI does is identify how extreme the price currently is over compared to the recent period of time. So in this case the last three bars. So when the RSI is at positive extreme, as we can see here, the price has moved up very strongly relative to the last three bars of price movement and the opposite is true here. This is a very low reading and this shows on the chart here you can see there's very strong negative price movement leading up to this reading. Now the RSI oscillates between 0 and 100 and depending on what period of RSI you use, those oscillations will be faster or slower. So a two period RSI for instance, which is quite common for mean reversion trading strategies, is quite volatile. It fluctuates up and down very, very quickly. And a 20 period RSI which you might use to identify a longer term pullback, fluctuates much more slowly on this chart. You know I've got a three period rsi. I like to use a two or a three period RSI on my chart on in my mean reversion trading strategies because they do a good job at picking short term reversal points, short term extremes, which is exactly what we want out of mean reversion. So the way you would use this on the entry is you might say, okay, we've got an uptrend here and we want to hold, we want to wait until we get a short term decline in the stock price, that's very sudden. And that is typically indicated by an RSI dropping below a certain level. And for RSI 3, you might enter long when the RSI drops below maybe 5 or 10. For an RSI 2, you might enter when the RSI drops below a value of 2 or 3, depending on how frequently you want to trade. And the way you would basically tune the system is.

The more frequently you want to trade, the the higher the threshold is where the RSI has to drop down. So if it has to drop down to a five, that's going to trade much less often than if you only require it to drop down to a value of 10. So the RSI threshold for the entry is one of the key components in your mean reversion trading strategy that you're going to vary and optimize to find the best values for your particular markets that you're trading. So RSI 2, RSI 3, both very common for mean reversion trading strategies. So RSI is the first indicator. What's the second one? Second indicator is Bollinger bands. Now, I've highlighted the same bar here, and what you can see is as the price falls at an extreme, it tends to go outside the lower Bollinger band. And in a. That's in a bull market. We're looking for a dip because we're going to buy the dip. So we look at the lower Bollinger band. Now, in case you've never used Bollinger bands before, I've got a blog post on Bollinger bands you can have a look at. But in essence, a Bollinger band is a band that wrap around a moving average. So let's say this chart shows you the 15 period Bollinger band with two standard deviations. So what it does is it draws a 15 bar moving average through the middle of the price and then it adds two standard deviations of price above and two standard deviations below. So as the price gets more volatile, the Bollinger bands expand. As it gets less volatile, they contract. And you can see that here. Here's a period where the volatility is expanding in this up move and the Bollinger bands are quite wide further apart. Here's a period here where, let me just highlight this with a bit of a circle there. Here's a period where the price action has condensed and contracted and the volatility is low. So the Bollinger bands come together. So Bollinger bands measure volatility. And if the price is in an Uptrend and it falls below the lower Bollinger band. That can be a really good mean reversion entry. Okay, so that's Bollinger bands. You can see that Bollinger bands are a great way to pick short term bottoms and short term rallies in a short term bottoms in a bull market and short term rallies in a bear market. So you can enter. The third indicator that you can use for mean reversion trading is stochastics. Now, stochastics are probably one of the most well known oscillators and they, they work in a similar way to RSI in that they'll, they'll oscillate between 0 and 100, they'll fall during a down during a correction, and they'll rise during a rally. And you can see in the pane at the bottom here that when the price is moving up, the stochastics are up near the top. When they have a sudden dip like here or here, rather, the stochastics fall. Now you can enter long on a mean reversion strategy when the long term trend is up and the stochastics cross below a certain level. Now one of the interesting things about mean reversion compared to trend following, say is, is in mean reversion, you don't wait for confirmation. So you're not waiting for the price to start rallying before you get in to ride the rest of the trend, the rest of the rebound. Rather, you're buying on the move against the trend. You're buying in anticipation of a bounce back. So that's why in mean reversion trading strategies, whether it's RSI or Bollinger band or stochastics, you'll tend to buy when that indicator crosses below a certain level or the price crosses below the Bollinger band. In the case of Bollinger bands, you're not waiting for it to cross back up. Because if you wait for it to cross back up, it's too late, you've missed the bounce, and then there's not much profitability left. So you've got to put your big boy pants, your big girl pants on, and you got to buy in the middle of the fear in order to be profitable with this trading strategy. And that's why psychologically, mean reversion trading can be quite hard. So stochastics is the third indicator. The fourth indicator, which I like to use for.

Mean reversion trading, is actually the number of consecutive bars in one direction or the other. Now this is a nice, simple indicator which I really love, particularly for mean reversion. And what it does is you look at how many bars in a row or how many bars set since. Yeah, how many bars in a row the price has moved in a certain direction. So if we look here, I've got the number of consecutive up bars and the number of consecutive down bars, both plotted. So let's have a look at an example here. No, here, let's do this one. So you see here, the price has moved, has closed. Lower, lower, lower, lower. And you can see if we go down and hover over this, we've had three consecutive down closes at this point. And here.

We'Ve had 1, 2, 3, 4, 5 consecutive up closes. Now if I just get rid of these lines, when you look at the chart, let me zoom out, you can see that in general, the number of consecutive up or down closes is pretty low. Two, three, maybe four occasionally.

But every now and then there's an extreme like here's. Let me highlight one chart here. Here's an extreme.

Here'S another extreme.

Here'S another extreme, and so on. So these extreme numbers of closes in the one direction can tend to be really good entries in a mean reversion trading strategy. So you might look for an uptrend and then you might find, wait for five bars down in a row in the middle of that uptrend and then enter on the fifth bar down. That would be a really good place to enter because there doesn't tend to be that many down days in a row in an uptrend. So if you buy on the 4th or the 5th or the 6th down day in a row, often there'll be a bounce back very soon after that, either the next bar or the bar after that. So the number of up or down bars in a row can be really, really powerful as an entry in mean reversion. Okay, so the next indicator that I want to talk to you about for mean reversion trading is internal bar strength. Let's have a look at a chart that shows internal bar strength. So what is internal bar strength? Before I really get into how do we use it? IBS internal bar strength is a measure of where the share price closes relative to the high and the low of the trading day. If it closes right in the middle of the high and the low, then IBS is 50. If it closes right at the top, the IBS is 100. If it closes right at the low, then the IBS is 0. So how do we use this for mean reversion trading? Well, let's Have a look at this chart of the S&P 500. Again we'll zoom in and have a look at some examples. So let's have a look at this bar here. So what happened on this bar is the price started, it opened at what price here? It opened at 4204 and that was the high of the day. And it went all the way down as low as 4164 and it closed just a smidge above that. So if we look at the internal bar strength of on this day.

Here, the internal bar strength was 0.05, which basically means that 95% of the price bar was above the close. That's a very oversold day. And for a low IBS in an uptrend is a great place to enter long in a mean reversion trading strategy. Contrast that with the next bar just here. And this bar opened at 4173 and it moved all the way up and closed at 4224. And the high was just a smidge above that. So the IBS or the internal bar strength for that bar is 0.97, which means that 97% of the price bar on that particular day was below the close. That's more like an overbought day. Now, as we know, in an uptrend, in a bull market we're looking for a dip to buy in anticipation of a bounce for mean reversion in a downtrend. In a bear market we're looking for a rally to short sell in anticipation of a correction back down to the trend in a in a down market. So in a bull market we're looking for a low IBs to buy for a bounce. And in a bear market we're looking for a high IBs to short in anticipation of a collapse. So that is how you would use internal bar strength. And as you can see, this fluctuates back and forth very, very quickly. And so internal bar strength does tend to give you a large number of signals. And there's a few different ways you can do this. You might average the IBS over a couple of different days. You might use it as one extra filter in your trading strategy. So there's several different ways you can incorporate this. But these five indicators are really powerful and I've got trading systems that have used all of these to develop mean reversion trading systems. So just quickly. Again, the five indicators that we went through for your mean reversion trading strategies are the relative strength index or RSI BOLLINGER bands, the stochastic indicator, the number of consecutive up or down bars, and lastly, internal bar strength. Now, of course, there's many other indicators that you could use for mean reversion trading. Pretty much any oscillator can be adapted for mean reversion trading, anything that looks for oversold and overbought levels. But these are five that I've used and found quite some success. You may have others, but these are a great place to start for your mean reversion trading strategies. So that's all for this video. In the next video, I'm going to give you an example of a mean revision trading system to bring this whole thing to life. So click Click below to watch the next video. Or if you're on the blog post, scroll down just a little further and I'll see you there. That's all for this video. Bye for now.