Mean Reversion Trading Strategy, feat. Becky
Becky and Kendra created this Market Mamas day trading psychology podcast to share all the growing pains and inner workings that developing traders experience. We are always looking to be of service in helping to guide traders and spread awareness of the amount of hard work and dedication it takes for success in this journey. In this episode/blog, Becky is going to talk all about her favorite trading setup that she trades at least a few times a week and we’re pretty sure you’ve all likely heard of. That is the mean reversion setup!
Mean reversion opportunities in trading can happen very frequently. For the US futures indices specifically, statistically they will often be range bound or rotational up to 70% of the days. It is during those consolidation periods that mean reversion can be a frequent opportunity. This can be observed and traded with a few different tweaks on the system. There are techniques with this both early in the regular trading hours session and at the end of the day’s session.
Early in the session, there could be a setup where the overnight session was rotational and we are opening within the previous day's value area. In that setup, if we are towards an extreme of the value area and potentially the standard deviation bands, then there's often a setup where price will trade back towards the naked point of control (POC) from that previous day's session. This is an early session naked point of control setup as well as a mean reversion category of trade, and one of Becky’s very favorites. It is not always obvious though and we definitely must factor in many variables, as with any trade, before entering. But if this is a setup that you have studied and traded many times, you can start to gain an intuitive feeling for it. The confluences will start to compound prior to market open, and the likelihood of early and quick success with this setup will become palpable as you study it. For Becky, if she sees a divergence in the direction she is looking to trade, a fatigue in the candles along a 2 SD band, a market condition that is rotational, and a naked POC within range of the value area we are opening inside of, she has to practice restraint often to still honor her intended position size per her system and not throw all her leverage and the kitchen sink at these trades! This setup is one that Becky sees the most clearly, as it really is quite frequent.
The core of mean reversion trades revolves around the auction market theory and the understanding that the market functions by having buyers and sellers present and exchanging contracts or shares. For every buy order, someone is on the other end of that trade and they took a short. There is give and take, push and pull. And the large institutions with big orders will often need to take time and patience to build a position and/or liquidate one, so consolidation periods occur as these phases of the market iron out who will remain in control of the greater direction. What that feels like as a day trader is a directional push intraday, followed by a period of exhaustion/ accumulation/ distribution, and then a correction back to a point of previous support or resistance to test the greater intentions of the market.
Where the market tops or bottoms out before bouncing back inward can be tricky to identify and that task is not to be taken lightly. Essentially, with these opportunities, you aim to catch a turn in the market. So, you need to be cautious with risk management and back test the heck out of executing on this strategy so you can rapidly in real time identify what supports a mean reversion trade, vs what is a fake out and it is actually a trending phase. Because let us tell you from experience, when Becky has faked herself out with one of these setups in the past that was not actually market fatigue for a pivot, but rather a flag in the heart of a continuation move, that can get dangerous in a hurry without appropriate protective stop management. In those two potential scenarios, it is so important to have clearly preplanned your risk management strategy and exit plan if prices do not revert back inward.
Often you can get really awesome risk management with these setups though because you are basing your entry off of a doji or engulfing candle at your level of interest and entering based on a pivot candle pattern and data. That then tells you exactly where your protective stop needs to be placed and left at. Because, from personal experience, you do not want a naked trade or a loose stop loss placement because if it was a balancing consolidation moment within a directional move, you can get killed very quickly when Miss Market takes off again! But, if it is a pivot you are trading at back towards a mean target, then just respect that part of your setup, as well as your position size for your account. If the trade is wrong, then you will be alright with a smaller/ reasonable stop hit. That is the risk of trading, and a part of our trading game as professional risk managers.
That’s a beautiful part of trading - the endless potential if we are humble and open enough to learn them all, not just the intuitive ones for us.
~ Becky
A big factor with this strategy is that the exact location of the target, or mean, is not a static point. It is variable based on time of day, type of market, range of the session, and momentum or volume in the day. It can be identified as the intraday VWAP, it can be a recent previous point of control (POC) as previously mentioned, it can be 50% of a range we are trading into, and it can even be a trend line on a gentle, slower directional day. As you can see, it is a subjective location, so I have found that I do better with taking profits on the conservative side. For instance, if I am aiming for VWAP or a naked POC, I will set my take profit a few points closer than the tick of the target, as honestly, there is variability on these targets from platform to platform and depending on the time frame the trader is focusing on.
For another fair warning, if many traders are aiming for the same target and also appreciate the slightly early target to get a fill theory, the price could never directly tag a target, even though that was the trade setup and it essentially does play out. It’s good to have precautions in place to avoid that, such as locking in your trade just before the targets actually get tagged. Yes, it also can sting to see prices fly through your target and keep moving, as then we could be frustrated at leaving so many points on the table when we had a great entry. But if the trader is in with full size, it’s best to try to respect the fact that we do not have to take all of a move to be nicely profitable. And this setup, mean reversions, they have a target that we identify before we get in the trade. And we want to honor our trade plan more than we need to take an entire move at this point in our careers.
In the last 3 years, Becky has mostly focused her trading on the futures markets, and specifically the ES, or S&P 500, and YM, or the Dow Jones Industrial Average. From her trading experience near daily for a few years, plus back-testing, and learning from mentors, you learn over time how your instrument moves. And that is an edge in itself. Just that familiarity with a market. They each have a certain energy, tendencies, repeatable patterns… Of course there is variability and irregularities in this, but you can learn her moves and get better at anticipating them as they are setting up with time and attention. And for all our beginner traders out there, this is not a thing that can be rushed. You just have to keep showing up and learning, watching, asking questions, and trading and feeling the outcomes of your trades.
One thing Becky has noticed about both ES and YM is that at least a couple days a week, there will be a decent mean reversion setup in the last hour and a half of the NY session, even, to some extent, on her trending days. And that is, at least partially, psychologically driven and just how she moves. Day traders want to lock in their profits. If they’ve held a trade from one end of the day to nearly the opposite, we can surmise that a potential profit taking from traders who do not hold overnight may take place. An exhaustion as well as satisfaction from those traders who’ve been in the larger day’s move and are then done. And, if you notice on a daily chart, most candles have a wick on the top and on the bottom. How do wicks form? They are a tip of a move in the observed time period, such as a day, and then price’s pullback before that time frame closes, aka, the end of the day. Hence, the wick on a daily candle IS, at least in part, the size of her mean reversion before market close.
Additionally, towards the end of the day, you will gain powerful data from the day’s Market Profile and Volume Profile that will give tells on the potential of how the day will close. Utilizing the data from those two important trading tools can show you where the bulk of the day’s trading has taken place, as well as where buyers and sellers have fatigued within the day. This is a potentially great setup for the end of the day and is why Becky will start watching how the market has moved each day that she is home and potentially able to take another trade around that 11:30 PST.
Attempting to catch and fade the end of a directional push is not without risk. As a trade setup, it is more appealing to Becky, but cautiously so. We think all traders are variable on this topic but generally prefer one trade setup over the other, trending vs mean reversion, as Kendra and Becky are opposites on this. As Becky loves a mean reversion setup, she has to constantly, daily remain cognizant of this bias in her. And watch carefully for her data to strongly support a setup or just not engage or attempt it in sim if the opportunity is less obvious. Because she has absolutely lost in glorious fashion when she was SURE this is the setup. Becky admits that she could attach to that bias in an overconfident mindset and potentially over leverage and/or be too loose with her stop in order to be right. But those choices are not sustainable. Overconfidence like that can wipe a person out!
That being said, mean reversions really are a regular setup for Becky and routinely quite profitable. But nothing is an always in trading and respecting the game of risk is required to stay in the game. It’s a sign of growth and maturity as a trader that we are able to clearly identify what our A setups look like and how we like to trade them. We can do this while respecting the other opportunities in the market as options to study, practice and learn to love as well! As Becky is actively working to improve her trend trading each week as well! That’s a beautiful part of trading - the endless potential if we are humble and open enough to learn them all, not just the intuitive ones for us.
Who else loves a strong mean reversion trade?!?! It is a very common trade opportunity, especially in the US futures markets, so we imagine there are many of us that thoroughly enjoy capitalizing on them. Tell us your experiences on this topic through our contact us page if you have a minute. We love hearing from you all and comparing notes! Thank you to everyone who is subscribing to our podcast, reading our blogs, and providing us feedback! We love talking about our favorite subject - trading! Miss Market is abundant for those of us that embrace a growth mindset and pursue deliberate practice in learning her tells and our own tendencies. Our best trading days are ahead! We wish you all the very best. Happy Trading!