An alternative to seeking out candlestick patterns or breakouts is to use a mean reversion trading strategy. This approach often goes overlooked, but statistics demonstrate its potential profitability in Forex, particularly in swing trading. Historical data shows that the best swing trading signals frequently align with mean reversion indicators.
Understanding Mean Reversion in Forex
Let’s examine the 28 major and minor Forex currency pairs over the past six years.
A simple mean reversion strategy involves identifying when the price becomes overextended. While there are many indicators to measure this, we will focus on something straightforward: just the price.
Over the last six years, the probability of any of these Forex pairs moving by more than 2% from a weekly open to a weekly close is about 1 in 8—a notable event. Suppose we open a trade in the opposite direction of such a move exceeding 2%, holding the position for one week.
This mean-reversion trading strategy generated an average profit per trade of 0.25%*.
Comparing Mean Reversion to Trend Trading
In contrast, consider a strong trend trading strategy using the same time frame and currency pairs. In this strategy, a buy trade is made at the end of any week that closes above the price three months earlier, or a sell trade is made if the opposite is true.
This trend trading strategy yielded an average profit per trade of 0.02%* but produced about eight times as many trades as the mean-reversion strategy.
To further illustrate, let’s refine the trend trading method.
If we only enter trades in the direction of the three-month trend when the prior week closes in the same direction, the strategy becomes unprofitable, with an average loss per trade of -0.02%*.
However, if we trade in the direction of the three-month trend but only when the previous week closes against the trend direction, the strategy becomes more profitable, with an average profit per trade of 0.07%*. This adjustment also produces a consistently rising equity curve over time.
Combining Strategies for Higher Profitability
What happens if we combine these two strategies? For instance, we only take trades when the price has moved by more than 2% at the end of a week against the three-month trend, anticipating a reversion to the mean.
This combined strategy generated an average profit per trade of 0.27%*.
*Note: All profits and losses are gross and exclude typical spreads, commissions, and overnight financing costs.
Bollinger Bands: A Popular Mean-Reversion Tool
One of the most well-known mean-reversion indicators is the Bollinger Band. In Bollinger Band trading, you typically enter a position when the price reverses off an outer band and exit when the price approaches the central band. There are also more advanced Bollinger Band strategies that traders can utilize.
Previously, we focused on simple price levels, but a more sophisticated swing trading approach can incorporate Bollinger Bands or other oscillators to enhance mean-reversion strategies.
Final Thoughts on Mean Reversion and FX Options Info
If you dislike leaving trades open for several days, historical data clearly shows that mean-reversion strategies often offer better odds over time, either alone or in conjunction with momentum or trend strategies.
This is not to suggest that breakout trading is unprofitable, but rather that without a robust method for selecting which breakouts and currency pairs to trade, the odds may work against you. For those leveraging FX options info, incorporating mean-reversion strategies can provide a compelling edge in the Forex market.
