Mean reversion is a concept based in statistics that assumes prices will move away from their ‘mean’ value in the short term while always returning to it in the long term. This theory cannot be confirmed given that markets are to an extent random and thus unpredictable, but there are many historical examples to support its relevance in asset classes like forex, interest rates, and stock volatility.*
Historical mean reversion
Mean reversion is especially popular among traders in forex markets. Even though many currency pairs can experience multiyear price extremes and high volatility, across decades the same pairs are widely viewed as mean reverting. The thirty-year chart of EUR/USD below illustrates how often the pair crosses the long-term mean.
EUR/USD historical prices
Managing price extreme risk
While forex pairs may revert to historical means over a long horizon, positions can still move against traders towards extremes in the short term. There are several methods traders can employ to mitigate such risks:
Scaling involves reducing lot size in order to save enough capital to act again if the market moves against you. By doing so, traders are more likely to capture the price extreme. In the example below, breaking the trade into four orders of 0.25 lots as the price moves higher allows the trader to profit from moves down from 158.00.
However, if the market continued to trade higher, then the trader would still have a full 1.0 lot of risk and could experience large losses.
EUR/JPY historical prices with scaling example
Stop-loss orders help traders to set limits for closing their position as soon as they open it. By setting exit prices upon entry using stop-loss orders, traders can automate management mechanics without having to actively enter closing orders in a moving market.
In the example below, setting a stop-loss order at 156 when entering the trade at 154 allows the trader to elect whether or not to open a new position at 158 without holding the initial position all the way to the price extreme.
Stop-loss orders can serve as a risk mitigation tool to limit adverse price action, but it should be noted that they do not guarantee a fill at a specified price; stop-loss orders technically trigger market orders when a price level is hit, and that market order can include slippage.
EUR/JPY historical prices with stop-loss order example
Another way to reduce risk in a forex pair is to diversify positions across pairs. Price extremes can exist simultaneously in multiple currency pairs; taking several different mean reversion positions reduces exposure to a single currency pair that could experience price extremes for extended periods of time.
EUR/JPY and GBP/AUD historical prices as diversification example
How to trade forex using mean reversion
Open an account to get started, or practice on a demo account
Choose your forex trading platform
Open, monitor, and close positions on forex pairs
Trading forex markets using mean reversion requires an account with a forex provider like IG. Many traders watch major forex pairs like EUR/USD and USD/JPY for potential opportunities based on mean reversion. Contrarians might go against a price extreme, while trend followers might go with it.
You can help develop your forex trading strategies using resources like IG’s Trading Academy. Once your strategy is developed, you can follow the above steps to opening an account and getting started trading forex.
Your profit or loss is calculated according to your full position size. Leverage will magnify both your profits and losses. It’s important to manage your risks carefully as losses can exceed your deposit. Ensure you understand the risks and benefits associated with trading leveraged products before you start trading with them. Trade using money you’re comfortable losing.
*IG US provides forex products only
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