A Simple Mean Reversion Strategy

Today I would like to share what I consider, the most fun strategy to trade that I personally use.

It’s simple, it works, and anyone can do it. Not only that, you can use it on any timeframe, depending on how much time you’d like to spend in front of the charts.
Some people really enjoy spending lots of time on the charts, while others only want to check in only a few times a day to adjust their positions. Regardless of where you are on that spectrum, this strategy can work for you.

Although, on the surface, the strategy is very simple and easy to get started with, I will be diving deeper into the inner workings of why it can work from a market structure perspective.
With that being said…

Let’s start with indicators. There is only 1 indicator that is required, and that is the 200 MA (Moving Average). This is what we consider to be “fair value” for any given currency.
We know prices will always return to their “fair value”, so this is where we want to GET OUT of the market. When price is above/below it’s “fair value”, is where we want to GET IN the market.
So the entry and exit rules are simple:

1. If price is above “fair value”, we can sell the asset. We exit our shorts once the market returns to “fair value”.
2. If price is below “fair value”, we can buy the asset. We exit our longs once the market returns to “fair value”.

Beyond these core rules, you can season the strategy how you like for specific entries be it using price action, RSI or other indicators. I will share more on my personal seasoning later…

At this point, most of you reading this are probably thinking, “This guy can’t be serious…” But, I can assure you, I am. Below are my own results from trading this strategy on EUR/GBP last month using the 1H chart:

The quick overview is, I have maintained a winrate of about 80%, I made on average 5.9 pips per trade, and my Value At Risk was -187. My median win is about 15 pips, and my median loss was about 20 pips.

And this is how it looks month after month…

There is one caveat to this strategy though… It will only work if you manage your account like it’s a real business that is buying and selling perishable products for profit.

I will dive deep into this later but what it essentially boils down to is this, you need volume to consistently make stable returns. Not volume in size, but volume in deals. This means you must do 2 things:

1. Stay Small
2. Trade Often

A short example to illustrate the point. Imagine a grocer who is selling tomatoes. Based on current market demand, they estimate they can sell $100 worth of tomatoes over the next week, and for every tomato they sell, they expect to make $1.00. But they have $3000 of cash.

Their expected value of each tomato transaction is $1.00, so mathematically, why not buy $3000 worth?

Even though they could try and buy $3000 of tomatoes to sell over the next week, the probability of $2900 worth of tomatoes going bad is so high, that it would be foolish to buy that much.
The expected value of the first $100 worth of tomatoes is very positive. However, the expected value beyond that point goes straight to -100%, the further you go beyond it, the fast you eat up the gains from the first $100 of tomatoes.

They have to stay small in tomatoes and use their money on other products.

This strategy is the same way. There is only so much you can bet on any single position or leg depending on when you get in the market, if you go over that, you are removing the edge of the system by taking on excess risk that will almost surely not pay off, similar to the extra $2900 worth of tomatoes the grocer could buy.

This would be a kin to planning your risk around the size of your mean or median loss.

Now even though the median loss is very small, you can see the Value At Risk is actually quite large. It’s very important to know this because when you are thinking about your risk, this is the number you need to make all of your decisions around.

If you used the median or even mean loss instead, you will take on excess risk that will almost surely not payoff, resulting in you losing money so fast it will make your head spin. Mainly because you will quickly find yourself way over-leveraged when drawdown inevitably hits.

So when you are planning your risk, assume the risk of every position is the VAR, not what your mean or median loss is. This will keep you small, which will allow you to trade often.

This is enough for the introduction. I will be posting my trades here going forward to provide a live example of how to use the strategy. I will also post deep dives into the areas mentioned above as time permits. This will include things like:

1. Hidden Risk
2. Estimating the rate of “inventory” perishing.
3. Handling the portfolio like a business.
4. Theoretical modeling drives the advantage of this strategy.

And more!

As I dive deeper into the strategy, and post about trades I am taking, you will start to see some terms that it’s important you understand.

The most fundamental ones are:

1. Fair Value: This is what is considered the fair or true price of the underlying. It is the value of the 200 MA and it is what we trade around.
2. Spread: This is the distance between the current price and/or your entry and it’s fair value.
3. Premium: This refers to the positive spread of an underlying. When the spread is positive, the market is trading at a premium.
4. Discount: This refers to the negative spread of an underlying. When the spread is negative, the market is trading at a discount.
5. Theta: In option theory, this is the rate at which the option’s price declines over time. In our model, this is the rate at which the fair value is converging towards our entry or the current price. This is the rate at which our position will lose its premium or discount over time. Traditionally, Theta was used as a shorthand for the Greek word meaning death (Thanatos).

Here is how these ones tie together as it relates to entries.

As for when to entry, I will get very in depth on when, but to put it simply, you want to enter when the spread is large enough that there is a good amount of premium or discount, but not too large as this is often where the drawdowns will strike.

This is also way you need to stay small and trade often.

As you enter, you are trying to capture a premium or discount from the underlying’s fair value. This premium or discount is going to decay at the rate referred to as theta (the speed at which the MA is moving toward your entry).

Theta is almost always working against you. As it does though, you will typically have the opportunity to average up. Never average down even if you can. Otherwise you end up like the tomato seller buying $500 of tomatoes when you can only offload a $100 worth.

Very interested! Following!!

I really like the tomato analogy

I think that the use of the word "spread" to describe a condition that occurs in this method will cause mass confusion, could be just me.

Carry on, interested to see how it all works.

very interesting i am in

i'm in too,
waiting more

Thanks for an interesting strategy.Would you be able to include charts and your buy or sell areas.Much appreciated.

Risk,

Why is the price at the 200MA considered "Fair Value"? Is this what the majority of large traders and Bank trading desks use as a de facto baseline?

Best,

Dave

There are different strategies based with return on 200 EMA, the problem is when the price does returns and it is a problem not yet solved. I am very curious to read about you and your strategy. If you know when the price will come back to the fair value, I guess that you have the holy grail.

This is a great question Dave! And I'll explain below. I was also asked some similar questions by another trader that provide context around this answer so will share that below as well.

His questions were in the quotes below.


I use the 200 because I like the “speed” at which it trades and the size of the premium/discounts it provides. It’s also a very popular one that is commonly used by both retail and institutional investors alike.

You could use any period you want though, the thing is, the smaller the MA, the smaller your opportunities will be. They will be higher in frequency but you need to weigh that against the cost. Vice versa for larger MAs. I also like the 200 for the reasons you mentioned, other people use it, so in that sense, you can have somewhat of a shared view on the market as a lot of retail and institutional traders alike.


This is true, and exactly the point. Price itself is stationary, meaning, by definition, it’s “fair value” will move, relative to any period you are looking at. This is not a novel concept, but is the backbone of the entire option pricing industry.

What is “fair” today, will not be “fair” tomorrow, and this will always be true. To improve your understanding of this, let’s look at how options are priced using the Black-Scholes model.
All the black-scholes model does is essentially this. It takes the assumed distribution of the underlying, factoring in a risk-free rate. It then takes any given strike price and uses the distribution to calculate the AVERAGE payoff for all possible payoffs according to the distribution. It then discounts this payoff by the risk-free rate.

The average payoff of today is not the same as tomorrow, this means the fair value of an option changes from day to day, decaying with Theta, just like our model. The options price over time is the moving average of all possible payoffs accounted for by the model over the duration of the option.

Different durations result in different prices, from a mathematical standpoint, all are assumed “fair”.

Does the fact that the option’s “fair value” changes day-to-day mean options can not be priced, sold, and managed by market makers?

Our “fair value” is just like that of an option pricing model, it’s a theoretical value with the explicit assumption that all things will remain equal. Depending on the volatility of the market, the true price after the chips fall can be smaller or larger than what the model says is “fair”.

Does this mean the model is broken? Not at all, all it means is, you need to understand the risk associated with the model’s error, and what conditions result in which direction the error occurs and it’s magnitude, as these are what you are actually betting on when trading the system. In options market making, and all options trading in general, its volatility…

I’ll expand more on what they are for our model, but for now, I think this should answer what you are asking.

I hope this clarifies the strategy/rational behind it for folks, and please post any other thoughts/questions you may have and I will answer as best I can.

Will also be posting more about detailed entry strategies soon! Just need to find time to get everything clearly laid out between keeping the kids busy and getting stuff done around the house.

These will be coming soon! I will also be posting charts with my actual entries this week as the market unfolds to show a better picture of how it's traded in action.

Just my opinion, but if I was to present an actual trading method, I would prepare all the documentation and charts beforehand..

Same thread and name on BP so not sure what you are selling but I'm sure it's coming...

Wanna bet on it?

I agree, and find it odd when people post a strategy and wait several days to post charts with clear entries...what's the point of this?

Oh guys...

You are missing the entire point of the strategy by focusing on specific entries and waiting for some specific indicator that will give you them...

And you wonder why most people lose at this game... They have no idea how the long-term winners actually play it...

We aren't trading the specific entries, we are trading the price as a whole, oscillating around a modeled fair value while staying small and trading often, to benefit from model error...

The MA in this strategy is strictly for modeling price, and using the model's error as your advantage, just like a market maker uses the Black-Schole's error in either the market's or the model's volatility assumptions to make money. By definition, if there was no error in the model's or the market's assumptions, you couldn't use it because the price would be truly fair at all times and there would be no reason for anyone to ever deal in it...

If you are struggling to understand this, I'd recommend you read this post here: https://www.forexfactory.com/thread/...5#post14490815

You are like a grocer thinking about which specific tomato to buy... measuring them all against each other, trying to figure out which one is the "best". By the time you finish your measurements, they are all rotten...

It's not so much about which specific tomato you want to buy, as much as it's about just buying the tomatoes when there is a high probability you can make a profit selling them at a "fair price". Most of the tomatoes are more than good enough. The ones that aren't are obviously rotten...

The reason I haven't been eager to post specific entry methods beyond what's shared already is, it's really simple to find potentially good ones. This is what makes the strategy very simple to grasp on the surface, but as I mentioned in the first post, the power is in the inner workings as it relates to market structure and managing the trades.

I could just post a couple of pics and call it a day. Another surface-level thread on here that provides no actual insight or discussion around the fundamental concepts that actually make people money... We could just throw it on top of the heap of all the other useless trading system threads in this forum...

Sorry to break it to you, but that is not what I am bringing to the table here... If that is what you like though, there are a lot of other threads on here that should fit the bill!

I will give you a little red meat though...

I've already told you when you know the price is discounted or going for a premium via the spread. The larger the spread, the better. The higher your potential margin...

Just like when you boil crawfish... Season it how YOU like... When the spread is large, the water is boiling...

Here is some seasoning that I like. The RSI on default settings (14). I know I know, another top-secret proprietary indicator for Erebus to chew on . Not sure if he has heard of it before!

If you can't figure out which tomatoes are most likely be ripe vs which ones will be rotten by the time you can offload them in the picture above, knowing everything shared thus far, let me know and I will try and clarify it further...

"It's not so much about which specific tomato you want to buy, as much as it's about just buying the tomatoes when there is a high probability you can make a profit selling them at a "fair price". Most of the tomatoes are more than good enough. The ones that aren't are obviously rotten..."

This reminds me of the M1 Countertrend Scalping Strategy. Hedging your bets that price will "eventually" return to its mean, but then we get into this on going debate about draw down.

very interesting i supose the money management is the key

Interested in following the thread and how to solve the mean reversion.
About the MA200 I would distinguish two cases.
1 when the price returns to the mean.
2 when the mean returns to the price.
Obviously case 2 is a problem when we find a trend.

Good thread.

case 2 is the definition of Theta. The rate at which our potential for profit dies. It’s usually working against us (90%+ of the time). This why the size of the spread is important. The more margin you have, the longer it takes the theta to eat your position.