TL;DR: Mean reversion is a trading style that bets a sharply overextended price will return to an average, for example the 20-day average. Common tools are the RSI and Bollinger Bands. The method only suits sideways markets; in a strong trend it often leads to losses.
What can you expect?
- Time per week
- On daily charts a few hours per week is enough for scanning and tracking, plus time for review. Intraday it takes much more time.
- Starting capital
- There is no fixed minimum. A larger amount helps to spread across several positions and keep costs low, but use only money you can afford to lose.
- Typical setbacks
- Several losing trades in a row when the market forms a trend after all, stops filled at worse prices on gaps, and trades that leave little after costs.
- Costs
- Order fees, spread and possibly currency costs. Because the target is often small, costs weigh heavily. Compare broker costs and include them in every trade calculation.
- Not suitable if…
- Not suitable if you do not want to use a stop, find it hard to accept losses or expect 'oversold' to always recover.
How it works
Mean reversion rests on the idea that prices often move back towards their average after an extreme move. Retail traders use simple tools for this, such as the RSI and Bollinger Bands on daily charts of liquid stocks or ETFs. The idea sounds logical, but it is no certainty: in a strong trend a price can stay 'too low' for days or weeks and keep falling. This page explains the method; it is not advice and no promise of results.
Core principles
- 1. Look for prices that have drifted far from their average, for example outside the Bollinger Bands
- 2. Use a second clue (such as RSI) and wait for signs of a turn instead of entering immediately
- 3. Trade only when the market moves sideways and is not in a strong trend
- 4. Decide in advance where you are wrong: a stop is mandatory
Step-by- step plan
- 1
Set up your chart
Use Bollinger Bands (20, 2), RSI (14) and ADX on daily charts. Start with liquid products, such as broad index funds or large stocks.
- 2
Choose only sideways markets
Check whether the market is moving sideways: low ADX, a flat 20-day average and price swinging up and down in turn. If not, skip the trade.
- 3
Find an overextended price and wait for a turn
Wait until price moves outside the lower band with a low RSI. Enter only after a sign of reversal, such as a close back inside the band.
- 4
Set stop, target and position size
Choose a stop below the recent low. The target is usually the 20-day average. Calculate position size from your maximum loss and compare the target with your risk.
- 5
Review and adjust
Record each trade in a journal and, after at least a few dozen trades, check whether the rules work in your situation, also after costs.
In detail
The idea: average and standard deviation
Mean reversion builds on a statistical idea: values far from their average often move back towards it. A simple measure of 'far' is the standard deviation, which shows how much prices typically fluctuate around the average.
In a normal distribution about 95% of observations fall within two standard deviations of the mean. Prices are not normally distributed: they have outliers and trends. A price outside that band therefore says something about being unusual, not about being certain to return.
The assumption mainly holds in sideways markets. Whether a price returns also depends on why it moved. A dip caused by panic may recover; a dip caused by a structural change usually does not.
Bollinger Bands as a framework
Bollinger Bands draw a band around a moving average, usually 20 periods with a distance of 2 standard deviations. When price touches the lower band, it is relatively far from its recent average.
Many traders use the middle average as a target and wait for a sign of reversal, such as a candle closing back inside the band. For sells the logic is reversed at the upper band.
In a strong trend price can 'walk the band': it stays against the outer band while the average moves along. The indicator then gives repeated signals that do not work out.
RSI and ADX: confirmation and market filter
The RSI measures the speed of recent price moves on a scale of 0 to 100. Readings below 30 are often called 'oversold', readings above 70 'overbought'. These are not buy or sell signals on their own. In a trend the RSI can stay in that zone for a long time.
The ADX measures the strength of a trend, not its direction. A low ADX (below roughly 20-25) points to a sideways market and is an argument to consider mean reversion. A rising ADX is a warning.
Combining price outside the band, a low RSI and a low ADX gives a stricter selection, but still no certainty. Always test rules on historical data and a demo account.
When it goes wrong: falling knives
The biggest risk is buying a 'falling knife': a price that looks cheap but keeps falling. That happens when a temporary deviation is actually a new trend or a structural deterioration.
Limit this risk with a fixed stop, small positions and liquid products. Avoid stocks with bad company news; a broad index usually recovers sooner than a single company with problems. Also watch the wider market: if everything falls at once, an individual signal tells you little.
Accept that some trades will lose. What matters is that your losses stay limited, not a flawless run.
- Basic knowledge of indicators
- Ability to wait for a setup
- Understanding of trending versus sideways markets
- Charting platform with Bollinger Bands, RSI and ADX
- Stop orders
- Trading journal
- 01 Price touches or closes outside the lower Bollinger Band (20, 2) and the RSI (14) is low, for example below 30
- 02 The market moves sideways: ADX below roughly 20-25 and a flat 20-day average
- 03 A first sign of reversal, such as a close back inside the band or the RSI moving back above 30
- 04 The stop can sit at a logical level and the target (for example the 20-day average) is reasonable relative to that risk
- 01 Price reaches the 20-day average (the usual target)
- 02 Stop hit: close without debate
- 03 A strong trend forms against your position, for example ADX rises sharply
- 04 The signal does not work within a few days: exit instead of hoping
Worked example
Hypothetical example (all amounts are assumed). Capital €20,000. You risk at most 1% = €200 per trade.
- Entry: €50.00. Stop: €47.00. Risk per share: €3.00
- Shares = €200 / €3.00 = 66.7, rounded down to 66 shares (position value €3,300)
- Target: 20-day average at €52.50. Gain per share: €2.50
- Loss if the stop is hit: 66 x €3.00 = €198. Gain if the target is reached: 66 x €2.50 = €165
- Gain : risk ratio = €2.50 / €3.00 = 0.83
The target is smaller than the risk here. The hit rate at which you break even (before costs) is risk / (risk + gain) = 3.00 / 5.50 = 54.5%.
Now with €8 costs per trade: loss €206, gain €157. Break-even hit rate = 206 / (206 + 157) = 56.7%. Costs therefore raise the bar.
This is a calculation example, not an expectation. How often your trades succeed depends on the market and can be lower. Use the break-even and risk-reward calculators for your own numbers.
Hypothetical example, not advice.
Work it out yourself
Risks and risk management
- 'Falling knife': the price looks cheap but keeps falling, for example because of bad company news
- A new trend: an indicator can stay 'oversold' for a long time
- Gaps (price jumps after the market closes) that cause your stop to be filled at a worse price
- Costs and spread eat into a target that is often small
- Set your risk per trade in advance (for example 1% of capital) and size the position from your stop
- Trade liquid products with stable fundamentals, such as broad index funds, and avoid stocks with bad news
- Spread across several independent positions and watch correlation between sectors
- Check the ratio of risk to target, and compare it with the hit rate you would need
Learn the basics
Key takeaways
- Mean reversion assumes a return to an average. In a strong trend a price can stay 'too low' for a long time.
- Combine several clues (Bollinger Bands, RSI, ADX) and wait for confirmation of a turn.
- The target (back to the average) is often smaller than your stop. The hit rate must therefore be high enough to cover costs.
- A stop is mandatory and position size follows from your risk per trade.
Frequently asked questions
How do I know if I am in a sideways market? +
Use the ADX: readings below roughly 20-25 point to a sideways market, above that to a trend. Also look at the chart: if price is not making clearly higher highs or lower lows and the 20-day average is flat, the market is probably sideways. It remains an estimate.
Which Bollinger Band settings are usually used? +
The standard is 20 periods and 2 standard deviations. Other settings give more or fewer signals. Change them only after testing on historical data, and use a second clue such as RSI.
Does mean reversion work on crypto? +
Crypto often moves strongly and in trends, and quiet periods can end suddenly. Mean reversion is riskier there. Limit position size, use a stop and be aware of the larger price swings and the risk of losing your entire stake. Crypto-assets are not covered by a deposit guarantee.
Origin
General technique