What is Mean Reversion Strategy and How to use it?

Mean reversion is a trading strategy based on the principle that asset prices tend to return to their historical average over time. This strategy involves identifying significant deviations from the mean using tools like moving averages, standard deviation, Z-scores, and Bollinger Bands. Traders look for overbought conditions to sell and oversold conditions to buy, anticipating a price correction. The strategy's simplicity and statistical foundation make it accessible and applicable across various asset classes. However, it requires accurate timing and careful risk management, as false signals, trending markets, and transaction costs can impact profitability.

Imagine Bitcoin is currently trading at $35,000, but its historical average over the past 50 days is $30,000. Using the mean reversion strategy, we identify this deviation as a potential opportunity for a price correction.

Step-by-Step Example:

Identify the Mean:

Calculate the 50-day simple moving average (SMA) of BTC, which is $30,000.

Detect Deviations:

BTC is trading at $35,000, which is $5,000 above the 50-day SMA. Assume this deviation is more than one standard deviation away from the mean, signaling an overbought condition.

Entry Signal:

Recognizing the overbought condition, you prepare to sell BTC, anticipating its price will revert to the mean.

Execute Trade:

Place a sell order for BTC at $35,000.

Monitor and Exit:

Monitor BTC’s price movement. As expected, the price starts to decline and eventually moves closer to the 50-day SMA of $30,000.When BTC's price reaches $31,000, you decide to close your position, locking in a profit from the trade.

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