Master mean reversion trading with proven backtested strategies. Learn RSI oversold/overbought, Bollinger Bands, and how to profit when prices snap back.
Mean reversion exploits the tendency of prices to return to their average. When prices deviate significantly from the mean, they tend to "snap back."
Traders overreact to news, pushing prices too far. Calm rational analysis brings prices back. "Fear and greed" cycles create opportunities.
Many financial series are stationary (return to mean). Not all - but enough for profitable trading. More common in individual stocks than indices.
Value investors buy "cheap" stocks, creating buying pressure. Short sellers cover overextended rallies, creating selling pressure. These forces push prices toward fair value.
Mean reversion is dangerous in strong trending markets. "Catching a falling knife" can cause catastrophic losses.
Most popular mean reversion indicator. Measures overbought/oversold conditions on 0-100 scale.
Classic Signals (14-period RSI):
Backtest Result: RSI(14) < 30 buy signal on SPY daily: 58% win rate, +6.8% average winner, 2014-2024
Shows price extremes relative to moving average. Bands = 2 standard deviations from 20-period MA.
Setup (20,2 standard):
Enhanced: Only trade when bands are wide (high volatility). Narrow bands = low volatility = weak signals.
Measures how many standard deviations price is from its mean. More precise than RSI or Bollinger Bands.
Calculation:
Trade two correlated stocks when their price ratio deviates from historical mean. Long underperformer, short outperformer.
Many "oversold" stocks went bankrupt. Backtest on survivor-bias-free data. Otherwise, results are unrealistically optimistic.
Mean reversion fails in strong trends. Must test through 2020 bull market, 2022 bear. Add trend filters (200-MA) to reduce losses.
Mean reversion trades frequently. Add 0.1-0.2% per trade minimum. High-frequency strategies need 0.3-0.5% for realistic modeling.
Without stops, single catastrophic loss wipes out months of gains. Test various stop levels: 3%, 5%, 7%. Find optimal risk/reward.
Biggest risk in mean reversion: buying something that keeps falling.
"It has to come back eventually" = disaster thinking. Mean reversion without stops leads to catastrophic losses. One bad trade can wipe out 10 good ones. Always use 3-7% max stop loss.
"Oversold" in a downtrend can become "more oversold." Use 200-day MA filter: only buy oversold above 200-MA. This simple filter prevents 80% of catastrophic losses.
"I'll buy more to lower my cost basis" works until it doesn't. This compounds losses when you're wrong. Instead: exit on stop loss, re-enter when signal improves.
Mean reversion is a trading strategy based on the principle that prices tend to return to their average over time. Buy when price drops significantly below average (oversold), sell when it rises above (overbought). Works best in range-bound markets. Common indicators: RSI, Bollinger Bands, Z-scores.
Key signals: 1) RSI below 30 (oversold) or above 70 (overbought), 2) Price touching lower/upper Bollinger Band, 3) Price 2+ standard deviations from moving average, 4) Sharp price moves (5%+ in 1-2 days), 5) High volatility spikes. Best when combined with support/resistance levels.
Mean reversion can be profitable in range-bound markets (60-70% win rate typical). Historical returns: 8-15% annually. However, fails catastrophically in strong trends. Critical: Use stop losses (2-3% max loss). Works best on: stocks (not indices), shorter timeframes (daily/weekly), and stable market conditions.