12 Oct Mean Reversion Trading Forex Strategy First Version #forex #money #market
Mean Reversion Trading Forex Strategy First Version
More at exacttrading.com Welcome to this video which describes a typical approach to creating a mean reverting trading strategy which could be applied to the Foreign Exchange markets and a pair like EURUSD. As you will see in the video this is a typical type of build people attempt but it is not necessarily the most successful model.
I will be making two videos in this series, video A and video B. In video A, this one, I will describe what most traders do, we will look at the build, what could be right about it and more importantly what could be wrong with it.
Before we get going on the description, let’s explain what we mean by ‘reversion to the mean. In any set of figures, let’s take the weight of some men, there will always be a group in the middle range who represent the mean or average weight. The mean can be mathematically calculated by adding all the values in the observation set together and dividing that summed value by the number of observations. Mean then is the average.
To take an example if we have three men whose weight is 80, 100 and 120 kilos respectively we can say that the ‘mean’ is 80+100+120=300/3=100
As regards FX trading the mean can be measured quite simply by looking at the average price over the last so many bars. Most traders will understand this concept where price moves away from an average and reverts back to it, this is essentially what mean reversion is, moving away from an average and reverting to it.
One of the issues I find with mean reversion trading is that you are snatching at small profits – by implication the mean is normally quite close and at the same time there is the distinct possibility that prices can get very much out of kilter and losses will be incurred, because you are constantly fighting with the market. Coming up with a mean reversion strategy that works based on taking small profits and exposing the method to the possibility to an extended drawdown is quite a steep challenge.
Here is how it normally works. Using a measure of volatility like Bollinger bands, price is shorted when the vol is over extended to the upside. When the vol comes back to ‘reasonable’ levels or it reverts to the mean the position is closed. Downside positions work in a reverse manner.
The issue with this approach is that the trader takes every over extended move in the market which he calculates as being ripe for reverting to the mean. Intelligent traders understand that when a market really starts to move it might be some time before it starts slowing and consistently trying to ‘fade’ such moves is the way to the poor house. This is the major problem I have with reversion to the means strategies
The next step in the process for traders who are more savvy and who understand trading to much higher level is to delay somehow entering subsequent trades once the first trade is starting to go bad.
It is one thing throwing good money after bad it is another carrying on digging when you are in a hole.
The idea then is to delay their additional trades waiting for yet more confirmation that the market is turning. Mostly trades do this by waiting a certain number of pips, of course they need the original pattern to repeat again.
Again what says that the market will turn at this second or subsequent point other than the fact the market is over extended and ‘due for a turn’.
The video explains how the strategy can be built using a pip target value in this case and running without stops but placing an overall stop loss on the account size, in the form of a percentage drawdown.
As you will see during the testing which I perform live, against this pair trying to pull pips out of the market is like trying to paddle upstream but ever so slowly being pushed back down again. There is a very good moment when I perform a test which slowly eats away the equity and just before the end of the run the 50% account drawdown kicks in.
In the next video I will explain a much easier way to approach mean Reversion trading and demonstrate the more positive results achieved during the tests.
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