How Mean Reversion Trading Strategies Work

So how do mean reversion trading strategies work? 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. Well, I want to give you an example, physical example, just to demonstrate what this concept actually is and how it sort of exists in the real world. Think about an elastic band. What we know is that stock prices tend to move in trends, but those trends are not a straight line. The price will oscillate above and below the trend. And when the price moves below the trend, it's like an elastic band being stretched and eventually it'll tend to snap back. And then when the price moves above the trend, it's like the elastic band being stretched in the other direction and it will tend to snap back. It's exactly the behavior that your mean reversion trading strategy is looking to capitalize on. Now this, there is a real edge in mean reversion because trends do move in these waves. And that is a very uniform, ubiquitous sort of behavior that you can see on pretty much any chart. Now the trick with a mean reversion trading strategy is to know when is the elastic band stretched enough to go short and when is it stretched enough to go long? And also when do you go long and short? So what I want to show you now, demonstrate now is just a simple set of indicators that kind of give you a feel for how these trading strategies work on the charts. Because in concept, okay, great, we're going to short sell when it's overstretched above the trend, and we're going to buy when it's overstretched below this trend. But when does that actually happen? Now, one of the simplest and most common indicators used for mean reversion trading strategies is the rsi, the relative strength index. And on the chart in front of me I've got a chart of the S&P 500 index and I've got plotted underneath it the two period RSI. Two period RSI. And the two period RSI is really useful for mean reversion because it identifies very short term periods where the price is oversold or overbought. And so if we look at this chart, this is a period where there's been a downtrend in the S and P. And I'm determining the downtrend looking at a long term moving average, a 200 day exponential moving average and a 20 period exponential moving average. There's no magic in these exact numbers, but clearly it's a downtrend when the short term moving average is below the long term moving average. Now, in order to get an edge in your mean reversion trading strategy, you want to make sure that you're trading in the direction of the primary trend. Now, in the case of the chart I just showed you, the primary trend was down. So we're going to be looking for opportunities to go short. If the primary trend was up, we're going to be looking for opportunities to go long. So looking at this chart here, if the primary trend is down, what we want to do is find areas on the chart where the price is overextended up, ready to snap back. Just like our elastic band. When the trend is down, we're looking for it to be overextended up and we're looking for it to snap back. So how do we do that? Well, here is a really good example on the chart right here in the middle.

The price has moved down quite strongly, found a base and then rallied very quickly over three days all the way back up above the 20 period exponential moving average. And then after that it sort of consolidated for a bit and collapsed back down in the direction of the trend. This is one of the, this is a perfect example of what we're looking for in mean reversion trading strategies. So how do we identify it? Have a look at something like the rsi. Again, this is the two period rsi. What we're looking for is a point on the chart where there's a downtrend in place and the two period RSI is extremely overbought. That means the price has rallied heavily strongly for over a short period of days to a point where it's now very overbought and much higher than what it has been in the very recent past. At that point in a downtrend when there's been such a strong rally, it's very likely for that to reverse and you can make a profit by going short. So if we look at this here, if I just click on the chart at where are we? You can see at this point here.

The RSI got the RSI two got to a value of 96, which is extremely overbought, which happened because the price rallied very strongly over three days up to this level. At this point you would say that in the downtrend it's overbought and very likely to snap back down. So you could short sell here and then hold in anticipation of this subsequent decline and then take profits somewhere in this move. This is how a mean reversion trading strategy works. Identify the primary trend. Find a period where there's been a short term move against the primary trend, getting your trade in the direction of the primary trend, wait for the correction back to the trend and then get out. These are short term trades. Let's try find another example. Find a bullish example. Okay, let's do. Okay, here's a perfect example right here. We've had this really strong rally. It's well above the 200 period moving average and you can see there's these little dips. Wouldn't it be cool if we could buy these at the bottom of these dips and then benefit from this subsequent rally? This is really good short term profits. Now if we look at the chart here, we can see that while it's in an uptrend, the RSI 2 got down to as low as 1.7 basically, which is quite oversold. And if you had a signal to buy that instrument when the RSI2 dropped below say 1.7, 1.8 and you just bought it then and held until the price rallied one or two days, then you're going to capitalize on this sort of move. See, we've got strong down movement. You get in here and then you've got a couple of days of rally. The same thing happened here and here. So mean reversion trading relies on these components. Identify the primary trend, find an overbought or oversold condition, enter in the direction of the primary trend and then exit several days later or one or two or three days later after the move has snapped back in the direction of the primary trend. That's how mean reversion trading works. So if you want to develop a mean reversion trading strategy, you need those components. What I want to do in the next video, click the link below to watch is go into exactly how you develop or how you combine the different components into a effective mean reversion trading strategy and how to make it work. What I've given you so far is a pretty high level overview. I don't recommend trading with exactly those rules. You need to combine them together into a whole trading system and back test it properly. So in the next video I'll show you a little bit more about how to combine indicators into a mean reversion trading strategy. So that's all for this one. See you in the next one. Bye for now.

Sam.