It’s no secret that cryptocurrencies have become a hot topic and an even hotter investment. People from all over the globe have taken risks and made lucrative profits from stepping into the thrilling crypto market. Traders might buy, sell, or seek an arbitrage opportunity with these enticing digital coins to make gains. But, they only do so by using the right tools and techniques for the crypto they have their eyes on.
There are many effective techniques to support trading habits. Some examples are trend-following, basket trading, position trading, pairs trading strategy, and mean reversion strategy.
But, for this article, we’ll focus on mean reversion since it’s a crucial strategy to know if you’re investing in the thrilling crypto market.
What’s mean reversion strategy?
To dig into how this strategy works, we need to understand what “reverting to the mean” is. So, let’s get down to brass tacks.
Mean reversion, i.e., reverting to the mean, assumes that the price of an asset will eventually come back to its average price over time. This theory believes that even when a stock moves quite far from its historical average by trending either upward or downward, it’ll still come back to its average at some point. In other words, mean reversion supports the phenomenon of extreme swings accompanied by a reversal and return to the mean. This is because the strategy sees any data on the tails of a normal distribution as outliers that will inevitably return to a period of normalcy.
Now of course in volatile markets (especially like the crypto market), outliers and abnormalities may not always return to normal– especially not within a short time frame. But, a mean reversion strategy argues that if you wait long enough, you should see an asset’s trending price return to its average.
So, is that true?
It’s like tossing a coin
Tossing a coin is a great example of how mean reversion works. When you flip a coin, there’s a 50/50 chance it’ll come up either heads or tails– (assuming that you’re not using your grandpa’s old trick coin that’s heavier on one side). Now, if you only flip a coin three times, it wouldn’t be crazy if you got tails all three times since there’s a 50% chance of getting tails. But, if you flip the coin twenty times, it’s highly unlikely that you’ll see it come up tails all twenty times. Instead, you’ll end up a bit closer to that 50:50 ratio. And, if you flip the coin ten-thousand times, the chances of revealing close to a 50:50 ratio is even greater. See where we’re going here?
Thus, a mean reversion strategy suggests that while you’ll see trends of more heads or tails at some times, you’ll come back to that average 50:50 ratio the more times you flip the coin.
But tossing a coin isn’t the same as trading on the cryptocurrency market.
Does a mean reversion strategy work in the crypto world?
In the high-stakes environment that cryptocurrency provides, it may not always be realistic to wait and hope for a trend reversal to bring a stock’s price back to its mean. This isn’t to say that a mean-reverting strategy won’t work for crypto, but it does mean it works better for some stocks than others. Sometimes, it may be more appropriate for crypto traders to employ a momentum trading (i.e., “trend-following”) strategy.
The strategy you use will depend on the history of the asset’s movement, like if it’s seen a moving average reversal in the past or other external factors that influence the market. These factors could include government regulations, inflation, and media news– like another tweet from Elon Musk (who’s proven to single-handedly cause abnormally high Bitcoin returns).
So let’s take a look at the difference between a mean reversion and a momentum trading strategy.
Mean reversion strategy vs momentum trading strategy
Assuming an asset’s price will come back to its mean is essentially the opposite belief of what momentum trading strategies argue. Momentum trading assumes that an asset trending upward or downward will continue in that direction. Thus, trend-following strategies see a change in price direction as the onset of a continuing trend, whereas mean-reverting strategies see a change in price direction as a short-term run that will likely reverse.
Let’s look at an example of how these two trading strategies play out in the dynamic crypto trading market. We’ll use the volatile and most well-known alt-coin, Ethereum (ETH).
If Ethereum falls…
Say the price of ETH falls 13% in 24 hours. Crypto traders who are loyal to a momentum trading strategy will begin to panic. They’ll believe that the price of ETH will keep falling, so they’ll make a move to sell as soon as possible. Conversely, traders employing a mean reversion strategy to this occurrence will assume that sooner or later, the price of ETH will rebound in value. Meaning, they’ll buy ETH with the belief that it will go back up to its average price.
In sum, momentum traders sell the losers and buy the winners in hopes that the price of the asset will continue trending in the same direction. On the other hand, mean reversion traders sell the winners and buy the losers in hopes that the price of the asset will regress to their mean value.
So, the question is: When should you follow a mean-reverting strategy when you’re trading crypto?
A glimpse into Bitcoin
Crypto technical analysis experts have conducted in-depth studies on Bitcoin (BTC) to determine when a trader would benefit from having a mean-reverting belief. What they found was that BTC tends to continue to trend at the MAX and rebound at the MIN.
This means that when BTC hits the local maxima, it typically continues an upward trend. So, a trader would likely benefit from betting on a momentum strategy when BTC trading is at the MAX.
On the other hand, crypto trading analysts have found that BTC bounces back even after seeing major drawdowns. This is due to BTC local minima being tied to irregular price action. So, this means a trader would likely profit from a mean-reverting strategy when BTC is trading at the MIN; since it should rebound to its average value.
Trading with a mean reversion strategy
To employ mean-revertive strategies, you have to know what a losing stock and a winning stock look like. How can you sell the winners if you don’t know when they’re flying high? And likewise, how do you know when to buy the losers if you can’t see when they’ve dipped?
Thus, to achieve the best results, many crypto traders use a combination of technical analysis tools to complement their mean-reverting approach. One of the most popular technical indicators is called a Relative Strength Index, or RSI.
RSI mean reversion strategy
RSI is a momentum indicator that tells you if the price of a particular crypto asset has an overbought or oversold price level. This technical indicator measures the speed of price movements by using a specific programmed formula. It gives traders a number between 0 and 100 that tell them whether to enter or exit a trade.
When the RSI oscillator is above 70, it means the asset is overbought. This tells a mean-revertive trader to sell, under the assumption that a trend reversal will take place and the price will go back down to its average. Conversely, when the RSI reads below 30, it means the asset is oversold. Thus a mean-revertive trader should buy with the belief that the price will come back up to its mean value.
A final word on mean reversion strategy
Like any other trading strategy, mean-reverting is best practiced in combination with technical indicators and risk management. When you use ChartPrime’s technical analysis trading tools, you’ll have the edge over other traders from the moment you enter the crypto market.