Last Updated on 21 September, 2020 by Samuelsson
If you have been trading the financial markets for some time, you must have heard about mean reversion trading methods and the swing trading style. But do you really know what mean-reversion trading is and whether you can use it in swing trading?
Mean reversion trading is a method of trading where you try to capture correctional price moves after the price has moved significantly away from its mean. And yes, mean reversion strategies work very well in swing trading.
Surely, you would like to know more about mean reversion: why it works, some strategies that are based on it, and how it works in swing trading. We’ll discuss all of that, but first, let’s understand what swing trading is.
What is swing trading?
Swing trading is a style of trading where you leave your trade open for more than one day, usually from a few days to a few weeks. The essence is to capture the individual price swings and quickly get out of the market before the price starts making the opposite swing (a pullback), or even better, hop onto the opposite swing if you have a strategy for that.
As you know, the price moves in swings — an upswing is followed by a downswing. Depending on the market condition, these swings may be of similar size (ranging market), or one swing may often be larger than the other (trending market).
Swing traders try to trade these price movements one swing at a time. In some markets, such as the forex market, it is common to try to trade both the upswings and downswings, but the case is different for the stock market. Stocks and equity indices tend to rise over the long term, so it is preferable to trade them to the upside, especially if you’re new to trading.
The preferred timeframe for swing trading is the daily and 4-hourly timeframes, and most often than not, traders make use of technical analysis to identify tradable opportunities and when to open or close their trades. Interestingly, mean reversion is one of the most reliable technical analysis methods used by swing traders.
What is mean reversion?
The concept of mean reversion in financial trading is based on the popular statistical concept known as regression to the mean, which was first observed by Francis Galton. The concept shows that extreme events are often followed by normal events, as things tend to even out over time. In other words, for any given variable, the farther the value is from the mean (outliers), the more likely it is that it will revert to the mean.
In financial trading, our variable is the price of a security. When the price moves significantly away from its average — as it often does due to overreaction to some piece of news or similar stuff — it tends to retrace itself and move towards the average. But since the movement is not perfectly coordinated, it often overshoots on the opposite side and also tries to retrace to the mean again, thereby creating up and down price swings around the mean, like in the picture below.
Since this oscillation is a regular feature of price movements, traders have tried to create trading strategies around it. But the key thing is knowing when the price has extended enough and is ready to revert — what traders refer to as an oversold or overbought market (see the picture above) — as well as estimating the average price around which the price swings up and down.
An oversold market is when the current price of an asset is significantly lower than its average price, while an overbought market when the current price is significantly higher than the average price. There are many methods traders use to identify oversold and overbought market situations and also estimate the mean value. We’ll discuss all those later under the mean reversion trading strategies. Meanwhile, let’s see the reason behind the mean reversion.
Why mean reversion trading works
Mean reversion works because the price always oscillates about its mean, and the reason behind it is that market participants mostly act based on sentiments. The two main emotions governing the financial markets, especially the stock market, are fear and greed. Here’s how they are manifested in price movements.
When a stock’s price is rising, investors and traders, most of whom are inexperienced, rush to buy the stock so as not to miss out on the opportunity. This creates a situation of higher demand than supply, which causes the price to shoot up further. As the price continues to rise, the more traders are greedily buying the stock, until it reaches a point where the early buyers start selling.
Up to that point, the demand-supply imbalance has been in the favor of demand, but now, that is changing. More people are willing to sell, so we are beginning to get more supply than demand. Of course, when there is more supply than demand, the price falls. As the price continues to decline, traders, especially the late buyers, become afraid and massively sell the stock, creating more supply surplus which causes the price to decline faster.
This situation is often dubbed a selling climax or capitulation, and it marks the end of the downswing. Meanwhile, the average price of the stock lies somewhere between the two extremes. So, at that significantly lower price, some traders will start buying the stock again because it is underpriced, thereby pushing the price up again.
Does mean reversion work in swing trading?
The simple answer is yes; mean reversion strategies work so well in swing trading, and the reason is simple. Swing trading aims to capture individual price swings, and you can achieve that with a mean reversion strategy.
A mean reversion trading strategy helps you to identify when a security’s price is oversold so that you can look to buy the security, or when it’s overbought so that you can sell. But when it comes to stock and stock indices, we advise you only look for buying opportunities.
When swing-trading with a mean reversion method, you aim to get out of the trade when the price has crossed the estimated average. Thus, apart from identifying the oversold and overbought levels, any mean reversion strategy you use must have a way of showing the estimated price average level.
One thing about using a mean reversion strategy for swing trading is that the win rate can be quite high, making it easier to execute your trades when you see a setup. However, they require using a big stop loss. So, when the losses come, they tend to be huge, and one loss can wipe out all the profits from many of the previous trades.
One way to accommodate the big stop loss is to reduce your trade size to a level where the big stop loss will still be within your acceptable account risk.
Some mean reversion trading strategies you should know
There are many mean reversion trading strategies out there, but we will focus on the ones we know that work. Also, we will only consider buy setups. Please note that what we discuss here is for explanation purposes for you to get some trading ideas you can use to develop a strategy that suits your particular situation. Now, let’s take a look at these five strategies.
Mean reversion with moving average
In this strategy, you determine a level below the moving average that indicates an oversold market. To get a reliable level, you need to experiment with different moving averages and try out different levels. When the price is trading below your chosen level, then the market is oversold, and you can look to go long.
Your entry trigger may be a reversal candlestick pattern like the hammer. You exit from the trade once the price crosses the moving average.
Mean reversion with RSI
This strategy uses a 2-day RSI and 200-day moving average to identify tradable opportunities. The price has to be above the 200-day moving average to show that the market has a general upside tendency. When the 2-day RSI crosses below 10, the market is considered oversold, and you can look to go long. You close your trade once the 2-day RSI crosses above 60.
Mean reversion with Bollinger Bands
Here, we use the Bollinger Bands indicator to determine the average price and the oversold level. As you know, the Bollinger Bands indicator consists of three lines: a 20-period moving average line at the middle plus a lower band and an upper band, both of which are located two standard deviations away from the middle band.
Below the lower band is considered oversold, while above the upper band is considered overbought. Look for a buying opportunity when the price goes below the lower band and aim to close your position once the price crosses the middle band.
Mean reversion with price action: the double seven strategy
This strategy is based on price action. You identify an oversold market when the price closes at a new seven day low. There, you may go long and close your position when the price makes a new seven day high. You should trade this strategy only when the price is above the 200-day moving average.
Mean reversion with price action: counting down days
Here, you simply count the number of days the market closed down consecutively. It is common to use three days. So, the rule is this: if the price makes three consecutive down closes, you may go long. Your exit is the first up day.
Mean reversion trading strategies help you to capture correctional price moves after the price has moved significantly away from its average. Interestingly, they work very well in swing trading.