Understanding forex mean reversion

[tmbaru 10]

Mean reversion is a concept in Forex trading that suggests that prices and returns eventually move back towards the mean or the average. The essence of this concept is the assumption that both a stock's high and low stocks are temporary and that a stocks price will tend to move to the average price over time.

 

Mean Reversion process entails identifying trading range for a stock and then computing average price using analytical techniques as it relates to earnings of the exchange.

It has led to many strategies involving the purchase or sale of stocks and other securities whose recent performance has greatly differed from their historical average. However, a change in returns could be a sign that the particular currency no longer has the same prospects it once did.

 

Reversion to the mean Forex trading is a statistical form of trading that is based on a pretty simply idea: the assumption that while the price will fluctuate between highs and lows it can generally be relied upon to return to its mean (or true) value with enough certainty to make trading the concept viable.

 

In other words, Forex mean reversion trading is simply waiting for a currency to deviate significantly from the mean or average value and then bet on the price returning back to the average value.

 

A simple glance at the concept just feels right and makes it seem like a viable idea. This makes trading systems very attractive as it is simple and straight forward to implement.

 

So is this a safe bet to invest in? Will the money that you will have invested bring back impressive returns?

 

Unfortunately, not all that glitters is gold, and so often things turn out to be not quite as easy as they seem. If we switch off our blind desire to make money for just long enough to see the flip side of it, we just might make an informed decision. So what are the flaws?

 

First and foremost, markets often trend. While we can never be absolutely sure, if a strong upward or downward movement is part of a bigger trend, there is a very real possibility that the prices will continue their upward or downward trend, even if they are already way above or below their mean value.

 

Secondly, market prices are not normally distributed. While it often appears that market prices are normally distributed every now and again, say every 5 or 10 years, movements happen that are so large and significant that we should not expect to see them if prices were normally distributed.

 

Thirdly, occasionally there is a great difference between what is the average (mean) price and the median (middle) price. For instance, take the following sequence of numbers 6, 7,20,70,95. The median is 20, but the mean value is wildly different, 33.

 

Last but not least, if it were really that simple, everyone would be doing it. If market prices really were normally distributed and the certainty of a reversion back to the mean could always be calculated mathematically everyone would be doing it and the strategy would lose its edge.

 

With those flaws in mind, is Forex mean reversion trading worth the risk? The beauty of it is that there are a few trading systems, however, which are in principle based on mean reversion and seem to work pretty well: Bollinger Bands and Keltner Channels, over and above these important indicators, other factors also come into play here such as crowd expectation and market psychology. It is important to understand these aspects when trading using the Forex mean reversion. If you do you will make millions of dollars in this currency market!!!

[PLFO 10]

Thank you for an interesting article. There is a system on the market for trading Forex mean reversion. It's basically an MT4 indicator with a set of rules. I would be interested to hear your thoughts as to whether you think the concept can be traded in isolation or whether it only works with additional technical validation.

[lisaanwood 10]

Really Great Info!!

 

Thanks for sharing this valuable information. I would like to share some more info that I gathered from by trading experience that could help other buyers as well.

 

Mean reversion is based on the assumption that price will always return (revert) to a mean (Moving Average). Mean reversion trading is built around the idea that high and low prices are temporary and a price will tend to go back to its average over time.

 

So a mean reversion trader will establish an average they think the price will revert towards, and levels they will trade when the price deviates far enough. This is similar to what market makers do in establishing a mid and standing ready to buy below that price and sell above it.

 

Here is an attachment showing 'Mean Reversion' in pictorial way.

[zdo 20]

lisaanwood,

 

Playing reversions is fine with indexes, etc. but...

With fx, wouldn’t it be more helpful to start a thread on ' mean excursions ’ ?