Mean reversion forex strategy

Markets Can Remain Irrational — There is a famous market adage that says that, the markets can remain irrational for longer than you can remain solvent. In other words, regardless of how confident you are in your market assumptions, you should not be so adamant so as to ignore the fact that the markets can and do often trade contrary to what appears to be reasonable.

Mean reversion traders need to be ever cognizant of this because of the very nature of their trading method which relies on bucking the current price action, which may appear to have stretched too far. Failing to recognize this in the market can lead to devastating losses that can be hard to overcome. Click Here To Join Mean Reversion Indicators Mean reversion trading techniques in the market are typically built on specific types of indicators.

These indicators can be in the form of technical oscillators , fundamental or economic indicators , or sentiment based indicators. Most traders are familiar with mean reversion indicators based on technical studies, but they are often less familiar with fundamental and sentiment driven reversion indicators. Technical Indicators — Certain technical indicators such as Bollinger bands, Relative Strength Index , Stochastics, and Williams Percent R are examples of technical based studies that provide overbought and oversold signals.

Essentially, these overbought and oversold signals tell us when the price movement within a specific market has either overextended to the upside in the case of an overbought reading, or has overextended to the downside in the case of an oversold reading. Below you will find an example of the Stochastics Indicator. The upper dashed line within the Stochastics indicator represents the Overbought level, and the lower dashed line within the indictor represents the Oversold level.

Notice how prices move back towards its mean following an Oversold or Overbought reading. Fundamental Indicators — If you routinely monitor an economic calendar , you will be well aware of the many different types of economic data releases that come out throughout the course of the month. Some examples of economic indicators that are important to watch for within the Forex, Futures, and Equities market include central bank rate decisions, gross domestic product, consumer price index, ISM manufacturing , NFP report, to name just a few.

For individual equities, a few important fundamental metrics include the price to earnings ratio, the price-to-book ratio, debt to equity ratio, and price-earnings to growth ratio. All of these aforementioned fundamental data points can be used within a mean reverting trading model. For example, the contrarian trader could compare the current CPI data to a multiyear trend of commodity prices , and use that data within their mean reversion model for predicting future inflation rates. Sentiment Indicators — Sentiment indicators can come in a few forms, but the underlying premise of using sentiment based indicators is essentially the same.

That is to say that mean reversion traders will often look at extreme readings in a sentiment index as a way to gauge the prevailing sentiment in the market. Often we will find that sentiment readings that are within an extreme range, either bullish or bearish, will lead to a reversal in prices within that market.

The basic concept behind this is that if everyone is bullish, then there is no one else left the push prices higher, which will lead to a price decline. Along the same lines, when everyone is bearish, then there will be no one else left to push the prices lower, which will then lead to a price rise. Another popular type of sentiment indicator which is used regularly in the futures markets is the commitment of traders index, commonly referred to as the COT index.

Often we will find that when there is an extreme divergence in positioning between commercial traders, who are essentially hedgers , and large speculators, who are mainly speculative funds, that prices may be close to a reversal point. This will usually favor price moving on the side of commercials. The weekly Copper futures price chart below illustrates this phenomena.

Notice whenever the commercial positions red line displays and extreme divergence with the large spec positions light green line , that the price tends to follow the commercial positions afterwards. Also note how the lines begin to converge once again, as the positioning beginning to revert to the mean.

In this strategy, we will incorporate the Bollinger band as our volatility mean reversion set up signal. The strategy that we will detail was first introduced by Joe Ross , a veteran trader and author. The strategy is called the Gimmee bar trading strategy. Essentially, this strategy seeks to look for potential reversals near volatility extremes, particularly within a trading range environment.

Here are the rules for a long trade signal: Prices should be exhibiting range bound price movement, with the Bollinger bands relatively far apart. The price must touch the lower line of the Bollinger band. Wait for the first up bar following the touch of the lower band. This first up bar is referred to as the gimmee bar.

Enter an order to buy one tick above the gimmee bar. Place a stop loss one tick below the gimmee bar. Exit the trade when the price is near or touches the upper Bollinger band. Here are the rules for a short trade signal: Prices should be exhibiting range bound price movement. The price must touch the upper line of the Bollinger band.

Wait for the first up bar following the touch of the upper band. This first down bar is referred to as the gimmee bar. Enter an order to buy one tick below the gimmee bar. Place a stop loss one tick above the gimmee bar. Exit the trade when the price is near or touches the lower Bollinger band. If you refer to the price chart below, you will find the chart of the US Dollar to Australian Dollar currency pair shown on the minute timeframe.

In order for us to validate this trade set up, we first need to ensure that the market is trading range bound, and that the Bollinger bands are relatively spread out. We can see the green bands on this price chart, which represents the Bollinger band technical indicator. Notice how the price action leading up to our trade set up appears to be trading within a well-defined range. Additionally, we can see that the upper and lower Bollinger bands have a good amount of space between them.

As the price action progresses, and we recognize these characteristics on the price chart, we would consider a potential mean reversion trade. If you refer to the magnified area on the chart, you will see a bearish bar which penetrates the lower band of the Bollinger band. Also, the candle immediately following that is a bullish bar. As such, the second bar is considered the bullish gimmee bar in this case. And these conditions now confirm our long trade signal.

The buy entry order would be placed one tick above the gimmee bar. You can see the gimmee bar noted on the price chart. The stoploss order would be placed just below the gimmee bar, which is shown by the black dashed line. This was phenomenon was first noticed by Chiang and Jiang. The model significance level and coefficients are close to those in paper, but the returns and Sharpe Ratios obtained are not as good as what the paper claimed.

Introduction The strategy is centered on uncovered interest parity UIP theory. UIP states that the change in the exchange rate should incorporate any interest rate differentials between the two currencies. By looking for patterns in the deviation from UIP we can potential generate abnormal returns. Interest Parity Conditions UIP states that an investor who borrows money in their home country and lends it in another country with a higher interest rate should expect a zero return due to the changes in exchange rate.

We construct the portfolio by taking a long position on the currency with the highest expected return and taking a short position on the currency with the lowest expected return. We hold these positions for one month, and repeat the process each month. There are two exceptions to this strategy: if all expected returns are positive, we take a long position only, and vice versa. We made an adjustment to standardize the mean-reversion.

This captures the mean reversion factor better than the author's technique. Each time we launch the strategy we use all of the available historical data prior to the start date to build the OLS model and uses that model for the entire backtest. We directly test our model on backtesting, because QuantConnect makes this easier. Method In order to apply the model, we need to first pull history data to build it.

The project can be briefly divided into four parts: the historical data request, model training, prediction and execution. Step 1: Request Historical Data The first function takes two arguments: symbol and number of daily data points requested. This function requests historical QuoteBars and builds it into a pandas DataFrame.

For more information about pandas DataFrame, please refer to the help documentation DataFrame. History [symbol], num, Resolution. DataFrame history df. We write it into a function because it's easier to change the formula here if we need. Using these updated factors together with the model we built we calculate the expected return.

To do this we requested 99 bars and use a pandas DataFrame to extract a data point for the end of each month. We use event schedule to execute the strategy at the first trading day, however, sometimes the first day of the month could be on the 2nd if the 1st falls on a weekend. To fix this we remove the data from the current month, leaving only the last 3 months of data.

We start from the second element of res res[1:] because res and params are different lengths. This function also used pandas DataFrame methods extensively. For more information please refer to pandas. Step 4: Initializing the Model In the Initialize function we prepare the data and conduct a linear regression.

The class property 'self. We will use this object each time we rebalance the portfolio. SetStartDate ,6,1 self. SetEndDate ,6,1 self. SetCash self. AddForex self. Log str df self. OLS df self.

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The extreme lines of the channel define the overbought and oversold zone. In this case, the price touches the upper line, which is a strong sign of buyer exhaustion - the market simply cannot cope with the pressure. Mean Reversion Indicator Another way to use the indicator is to determine the exit point from the location.

Let's say you have opened a sales order following a downtrend. The task is to determine when the trend will end and the price will turn in the opposite direction. A fairly reliable signal is the price exit in the oversold zone - hitting the lower limit of the channel.

This means that the market is running out, there will most likely be a rebound and it is time to lock in profits. Mean Reversion Indicator Following the same principle, you can place at a favorable price on trend rollbacks. For example, in the case of an uptrend, we enter or are added when you touch the lower bound of the trend channel.

If there is an uptrend, the price tends to move up from the average and then fall back to it. When the price comes back to the average, this may present a buying opportunity. If there is a downtrend, then the price tends to fall below the average and then rally back to it.

When the price is near to the average, this may present an opportunity to take a short position sell instead. The following is a one-minute chart of the Big Tech share basket , which is an exclusive offering on our platform. While not all movements around the moving are forecastable, many traders could use the average to identify trades in the trending direction. An intraday mean reversion strategy works best when a strong trend is present, combined with a moving average where the price tends to get near it and then moves in the trending direction.

It does not work as well when a strong trend is not present. Mean reversion forex strategy One strategy that traders may consider for forex trading is looking at how far the price tends to deviate from the mean before reverting back to the mean.

There are notable exceptions where there were large price moves, and these also tended to reverse near similar levels on the PPO. So, how could a strategy like this be used? Some traders may opt to enter a short position if the price rises above a common reversal level on the PPO, then drops below that level.

A target could be placed at the mean moving average, or 0 level, on indicator. The profit target the average is constantly moving, so traders may opt to update it with the completion of every price bar. To manage risk, a stop-loss has been placed just above the recent swing high that occurred prior to entry.

This helps to control the loss in the event that the price continues higher instead of going back to the mean. The same concept applies to long trades when the price dips below the common reversal point on the PPO and then rallies back above that level.

The horizontal line reversal point on the PPO or MACD will vary by asset, and traders may wish to place it at a spot where many reversals have occurred. A mean reversion strategy like this assumes that the price will continue to move as it has in the past. Price moves may get bigger or smaller, while still reverting to the mean over time. Practise mean reversion trading on the go Seamlessly open and close trades, track your progress and set up alerts Learn more Mean reversion and regression A regression line shows a single line that best fits a selected price series.

The price tends to oscillate around the regression line. The Raff regression tool on our trading platform can be used to plot this line for traders. Traders can select the tool, then select the first point in time and connect the tool to another point in time. A Raff regression is shown below on a Crude Oil Brent 4-hour chart.

The regression middle line highlights the dominant trend and the price tends to move around it. This may continue into the future. The upper and lower lines mark the furthest points that the price has moved from the regression line. These could indicate extreme price levels, where the price could reverse back toward the middle regression line. A regression is simply another way of measuring what normal looks like. For example, to carry out a pairs trade, select one of the instruments from the pair that you are interested in.

Select this product from the Product Library to open a trading chart. Next, in the Product Library, search for the other asset in the pair that you want to trade. Drag the name of that asset on to the existing chart. On the chart below, we have dragged West Texas Crude Oil on to the existing Brent Crude Oil chart to compare the two types of oil and look for potential divergence and a possible reversion to the mean trade.

Both assets now appear on the same chart. Traders can assess how they will enter and exit each trade and select the buy or sell buttons in the upper left corner accordingly. It is also possible to apply stop-losses and target to the order tickets.

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