BCGAME - Free 5BTC Daily Bonus!Traders often use different techniques to increase the probability of winning in the market. To achieve this goal, two useful indicators are: Reverse Average and Momentum. While the mean reversion strategy allows traders to determine whether big moves will be partially reversed or not, dynamic trading assumes that big moves will continue in the same direction. Both are effective strategies that should be understood by any serious trader.
What is mean reversion strategy?
Understanding Mean Reversion Theory
In finance, the mean reversion theory assumes that the price of a stock always tends to approach the mean price over time. This theory cites the phenomenon of how the most extreme events are often accompanied by a period of normalization. For example, if the S&P 500 falls 20% this month, the mean reversion theory predicts that it will fall less than that percentage the following month.
In simple terms, mean reversion states that when the price of an asset deviates too far from its average price, it will eventually come closer to its mean.
How to trade with the mean reversion strategy?
One way to implement mean reversion trading is to buy a stock after an unusually large drop in price, because theory predicts that the stock will rebound closer to its average price. There are other mean reversion indicators that traders use to get optimal results:
Technical Indicators: Average RSI Reversal Strategy
Many traders use RSI to complement their mean reversion strategy. RSI is useful because it helps them determine which assets have overbought or oversold price levels.
Overbought generally means that the price is expected to fall in the future, while oversold assets are likely to rise over time. Other technical indicators like standard deviation, money flow, distance from a moving average and Bollinger bands can be referenced to decide when to enter or exit average reversal trades.
Sentiment indicators to detect mean reversion
As markets often reflect crowd sentiment, some traders look to sentiment indicators to detect turning points. For example, many investors bought Infosys stock when its price dropped after the CEO's resignation, betting that the price will rise after the company resolves its management issues.
3 pair exchange
Trying to profit from immediate price movements can be riskier, which is why traders use an average reverse pair trading strategy to bet on spreads between two types of similar products. For example, gold and silver are generally considered to be correlated markets. If suddenly their prices move without correlation to each other, traders can use this to bet on the return of correlation.
What is dynamic trading strategy?
Traders who use the dynamic trading strategy buy bonds that show an upward price trend. They assume that once a trend is well established, it is expected to continue. This is a strictly technical trading strategy because it does not take into account the fundamental conditions of the underlying asset. Instead, it analyzes bonds by identifying their price trends and the strength of those trends.
How to use momentum indicators
Traders must be aware of various technical indicators to execute a successful momentum strategy. Here are some indicators that are commonly used:
tendency line
This helps to analyze price movements for a specific asset or stock. Trendlines are created between any two successive points on a chart. If the drawn line is sloping downward, it is an indicator of a downtrend. If the resulting line is sloping upward, the trend is either positive or bullish.
moving averages
A moving average line helps to eliminate market noise and identify the trend that is likely to prevail. If a stock's price is above the moving average, an uptrend is indicated. On the other hand, when the price remains consistently at or below the moving average, a downtrend is likely to occur.
The Average Directional Index (ADX)
The ADX indicator helps traders to calculate the expansion or contraction of an asset's price range for a specific period, which can be used to determine the strength of the trend. Its value ranges from 0 to 100. Values below 25 illustrate a market without direction, while values above 25 show a strong trend. Here is a pictorial representation of determining the value of an asset from the ADX indicator.
Average reversal vs. impulse: which is better?
Profit expectation and trading frequency
The mean reversion trading strategy works well in a typical market environment because bonds generally move in a specific range. However, the profits may not be huge. The quintessential mean reversion trading strategy has low profit and high frequency expectations.
On the other hand, dynamic trading involves less frequency because the market does not always move in a strong trend. However, a dynamic trade can potentially reap big gains, because reaching a strong price trend relatively early is highly profitable. Therefore, dynamic trading has greater profit potential but less frequency when compared to mean reversion.
Moving on
In conclusion, both strategies depend on market movement and the trader's own preferences. Traders are also free to combine mean reversion and momentum approaches to determine better entry and exit points.
