Components of a Mean Reversion Trading Strategy

Hey, Adrian here. And in this video, I want to share with you the components of a mean reversion trading strategy. I want to make sure that you think about mean reversion trading as a complete system to get you into and out of the market. And mean reversion is a little bit different to other trading strategies in the way you put together different components of a system. So let's jump in and have a look at the components of a mean reversion trading strategy. But before we go any further, make sure you hit the subscribe button and give this video a thumbs up so you if 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. So what is a complete trading system? This is a framework that I use to define a complete trading system. You have to understand what strategy is that you're working on, what markets you're trading, what time frames. Then that feeds into the system itself, which consists of setup, entry, pyramiding, exit and initial stop, loss. And then wrapped around all of that is the portfolio or risk management and position sizing rules. That system generates a certain set of results which you will monitor on an ongoing basis to make sure that it's performing as expected. And then every now and then, periodically, you're going to optimize and refine that system and the whole. Throughout this whole process, you're going to monitor your own personal psychology around that system and make sure that you've got absolute confidence in it. Now, that whole framework, while that's broader than mean reversion, it's very important for systematic trading in general. Too many traders think about just this trade or just this indicator. Whereas if you have a whole framework to guide you in your trading, it's a much more powerful way to think about things. Let's get into the components of a mean reversion strategy and talk about what exactly is required for each of these different components to make a mean reversion strategy work. So on the screen in front of you, you've got the central part of my trading system framework, which is the system itself. We've got the setup, entry, pyramiding, exit and initial stop, loss. And then wrapped around that, we have the portfolio management, risk management, and position sizing rules. So for mean reversion, each of these requires a certain style or method of thinking to get the system right and to make sure it's profitable. So in the setup, what you need to do first of all is identify the Direction of the primary trend. Now, the primary trend is super important because if we trade in the direction of the primary trend, we tend to have a higher average profit per trade. Mean reversion can work, can be profitable trading against the primary trend, but the average profit per trade tends to be much, much smaller. And one of the challenges with mean reversion is that typically the average profit per trade on mean reversion system is very, very low. And because it's low, it makes it much more difficult to trade well, to trade profitably, because any amount of slippage and excess commissions or mistakes can really ruin the strategy. So my approach is to trade in the direction of the primary trend with mean reversion because that gives you a bigger edge. Because when, if we go back to our elastic band analogy, if the trend is up and we're buying when it's oversold, there's a bigger snap back to the trend. But if the trend is up and we're short selling, so you know, we're counting on a stretch above the primary trend to snap back to the trend, that tends to be a smaller snapback because the trend is up. So it goes above the trend, then comes down, goes above the trend and comes down. They're smaller moves. So much better off if we trade in the direction of the primary trend. The second thing you need to do is ensure that your instruments are high liquidity. Now, now high liquidity is really important in mean reversion trading because again, the average profit per trade in mean reversion strategies is very, very small. If you're trying to trade small cap stocks that have low liquidity, then the slippage that you get from those stocks is going to absolutely kill the profitability of your mean reversion system. So the setup for your mean reversion trading is first, identify the direction of the primary trend. Second, make sure it's a very highly liquid stock. The third thing that you want to look for in a mean reversion trade is a high level of volatility. The higher the volatility, the better because that means the amplitude of the moves around the primary trend will be more, giving you a greater chance for profitability. So that's the setup for mean reversion trading. The entry for mean reversion trading, what we're looking for is an extreme overbought or oversold condition, depending on which direction we're trading in. We, we're waiting for the price to move a long way in against the trend so that we can get in and profit from the bounce back towards the trend or in the direction of the trend. So typically what we're going to do here is use an overbought oversold oscillator or a certain number of down bars, or a certain number of up bars to tell us that the price has moved strongly in that direction. Once it has moved strongly in that direction, we're going to get into our position and we're going to hold it until the price snaps back. Now, there's two ways to do this. You can enter once you've identified that it's an overbought or oversold condition, you can enter on the next bar at the open or today's bar at the close, expecting a snapback. That works. But another more profitable way to do it is identify the oversold or overbought condition first. And then secondly, put a limit order in the market at a bit of a bigger stretch further away from the price. So if we're going long, we're looking for a bull market, we're looking for an oversold condition, and then we put a limit order just a little further down so that the next day, if this price stretches a little more, our limit order gets hit. And then that gives us that bigger snap back in the direction of the trend. Typically, you get a higher average profit per trade if you enter on a limit order at a slightly bigger stretch than if you just enter at the close or at the open the next day. More complicated to manage, but more profitable for you in your account. So that's what we're doing when we're entering a mean reversion trade. Once we've entered a mean reversion trade, you're going to think about protecting your capital. Now most people will say you shouldn't trade a system without a stop loss. And look, that's probably true in most cases. The challenge for mean reversion trading is if you put a stop loss too close to your entry position, if it does tend to break the system. Because what happens is, let's say we're trading on the long side, we enter on a dip and the price has some short term momentum down. If we put a stop loss in there, often that stop loss will get hit before the bounce back in the direction of the trend. And so by adding a stop loss, at least a stop loss that's close to the market, what happens is we increase our losing trades and we reduce our percentage of winning trades. So it reduces the accuracy of the system. And the profitability or the expectancy of a mean reversion trading system comes from Having a highly accurate or high win rate, lots and lots of small wins, the occasional large loss. But if you put your stop loss too close, you get a larger number of losses and the profitability of the system breaks down. So in your stop loss for a mean reversion system, you want to use a much wider stop because what you're really trying to do is, is protect yourself against a real disaster situation where the stock dips and it keeps on dipping for a long time after that. If you have a wider stop like that, it won't get hit very often. It'll only get hit in the most dire of circumstances. And so your system profitability, your high win rate remains intact and the overall expectancy of the system remains positive. So if you put a stop loss in your trading system or your trading strategy, make sure you test it at different increasing widths and notice where the system performs best. And you'll see for mean reversion, it's at very wide stop loss levels. I'm talking on daily charts. 10, 15, 20, 25, 30% wide or more even, depending on how volatile the stocks are. You want your stop loss to be positioned a long way from the price action so you still get that benefit of the high win rate. So that's your initial stop loss. Pyramiding is the next consideration. Now, I don't do this, but there's some well known mean reversion trading strategies where you do pyramid into the position. And pyramiding means adding to your position as it moves in. Well, in this case, as it moves against you. So let's say you identify an oversold condition, the market's gone down and we buy a portion of our position hoping for a bounce back, but then it moves a little further against us. That's stretching that elastic band a little further. So maybe as it moves against you, you buy another bit of your position and if it keeps moving against you, another bit of your position, because what you're doing there is you're loading up as the elastic band gets more and more stretched. So when it snaps back, you've got more profit. Now, as I say, I don't do this. I tend to go in once on each strategy because I would rather diversify between multiple strategies, strategies that have more entries in one trade. But it's a perfectly legitimate approach, it's just not one that I tend to use. The next component for a mean reversion trading strategy is the exit. Now, this is very, very different than the typical trend following momentum, buy and hold mentality, because what we're Doing with a mean reversion trading strategy is we're exiting after a very small move in our favor. We want to profit from the bounce. We're not waiting for the whole trend, the whole move. If you want to profit from the whole big trend, use a trend following strategy. But for mean reversion, when it's oversold and we buy, when we get a little bounce up, we want to get out, take our profits because that's how we get the high win rate. If it's a short strategy, so the market's going down and it's overbought and we short sell when it collapses just a little bit, we're going to get out. We're not looking for the whole collapse down to zero, we're just looking for a small move in our direction. Now what does that actually look like in terms of indicators and rules? It could be exit after the first close in the direction of your trade in your favor. So if you're buying, the stock price is going up, has a dip, you buy if it moves up the next day, then you can exit on the close that day or the open the following day. One profitable up move or two profitable up moves is a pretty good mean reversion exit. Another mean reversion exit might be the RSI bouncing up to a certain level. Sorry, Siri, is getting in the way here. Another good mean reversion exit might be the RSI bouncing up to a certain level. So something like if you're entering on a two period RSI and say you entered when the RSI was below 5, you might exit if the RSI pops above 30 or 40, something like that, because that's a pretty small move in your favor, but it's enough to grab a bit of profit and get to safety. So mean reversion exits are quick, nimble and don't keep you in the trade very long at all. Typically the average trade duration on my mean reversion strategies on daily charts, 1, 2, 3 days, depending on the system. Yeah. So next we have the portfolio, risk management and position sizing rules. Now the biggest thing here to stress is that you want to keep your position small. In my mean reversion trading systems, what I do is.

Spread my capital over a large number of trades. I'm talking 10 or 15, maybe even 20 trades. Because I want to make sure that each trade is small. And the reason is meanrosion gives us a lot of winners, but the occasional loss tends to be large. The and I don't want to have a large position with a large loss hurt my account, so keep the positions fairly small. Make sure that you remember the size of the biggest loss when you run your backtest and you look at the range of trading outcomes, look at how big the biggest loss is and make sure that with your position size you're comfortable that that loss won't wipe you out or won't hurt you, won't push you past your drawdown tolerance. That's the key to making sure that a you stay profitable and b your equity curve is nice and smooth and isn't punctuated by these massive declines that are really hard to recover from. So these are the components of a mean reversion trading strategy. Later on in this video series and on this in this article, I'm going to share the advantages and disadvantages of mean reversion and I'll dig into the exact rules that you can use for each of these different components so you know for the setup for the entry, the exit, and the stop loss, and so on to bring this to life a little more. So if you're ready to watch the next video, click below or continue reading on this article. If you're reading on the on the website and I'll see you in the next section. Bye for now.

Sam.