There are many different types of trading strategies. Some traders trade with the trend buying high looking for higher highs or sell new low prices short looking for even lower lows in price, momentum strategies just look for a strong move to go a little farther, others trade a market inside a price range of support and resistance. What this article is going to talk about is the specific strategy of mean reversion, this is looking at prices as a kind of rubber band that stretches only so far and eventually snaps back to a historical long term average.
Mean reversion trading strategies consist of signals that bet on extended prices eventually snapping back from overbought or oversold conditions and reverting back to the mean of historical pricing. It is a trade that takes a position on a quantifiable technical signal that price has moved too far and too fast in one direction and the probabilities that it will return to an average are high.
One simple way to look for a reversion to the mean trade signal is by setting visual deviations around prices using technical indicators like Bollinger Bands or Keltner Channels that usually measure the distance from the 20-day moving average in standard deviations of price.
When a market drops dramatically or rises parabolically three or four deviations from the 20-day moving average the odds are that it will revert back to that average in days or weeks the majority of time. Of course this does not always happen as markets rotate from ranges to trends, and can go farther than anyone thought possible so you must always use a stop loss for the times when a trend continues and does not revert.
One strategy is to buy dips to the lower 3rd standard deviation Keltner Channel or sell rallies short to the upper 3rd standard deviation Keltner Channel and set a stop loss if price closes back outside your entry channel signal. Your profit target could be back to the 20-day moving average.
There is no magic or Holy Grail in reversion to the mean strategies and profitability comes from creating good risk/reward ratios, if it does not work out you should be stopped out for a small loss but if it reverts back to the mean then you should have a big win.
A mean reversion entry is taking a trade that is at short term extreme prices that has a good chance of returning to more normal long term price metrics.
Chart Courtesy of TrendSpider.com
This is not investment advice just one example and any trade you take should meet your own risk tolerance and return goals.