Here’s a step-by-step explanation of how it works:

1. Identify the Mean

• Objective: Determine the average price level around which the asset tends to oscillate.
• Methods:
  • Simple Moving Average (SMA): Calculate the average price over a specified period (e.g., 20-day SMA) to determine the mean.
  • Exponential Moving Average (EMA): Use a weighted average that gives more importance to recent prices.
  • Historical Mean: Compute the mean price over a longer historical period to establish a reference point.

2. Detect Price Deviations

• Objective: Identify when the price significantly deviates from the mean, signaling a potential opportunity to trade.
• Methods:
  • Standard Deviation: Calculate the standard deviation of prices around the mean to assess how far the price has deviated.
  • Bollinger Bands: Use bands set at a certain number of standard deviations above and below the mean to spot extreme deviations.
  • Z-Score: Measure the distance of the current price from the mean in terms of standard deviations.

3. Confirm the Reversion Signal

• Objective: Validate that the price deviation is a strong signal for reversion to the mean.
• Methods:
  • Technical Indicators: Use indicators like the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) to confirm overbought or oversold conditions.
  • Volume Analysis: Check if the deviation is accompanied by high trading volume, which can validate the signal.

4. Enter the Trade

• Objective: Take a position that anticipates a return to the mean.
• Methods:
  • Buy/Sell Based on Deviation: Buy the asset when it is significantly below the mean and sell or short when it is significantly above the mean.
  • Limit Orders: Place orders to buy or sell when the price reaches predefined levels of deviation from the mean.

5. Manage the Trade

• Objective: Control risk and optimize returns while the trade is open.
• Methods:
  • Stop Loss: Set a stop loss to protect against significant losses if the price continues to move away from the mean.
  • Take Profit: Set profit targets based on expected mean reversion to lock in gains.
  • Position Sizing: Adjust trade size according to risk tolerance and the magnitude of the deviation.

6. Exit the Trade

• Objective: Close the trade when the price starts reverting toward the mean or when predefined exit conditions are met.
• Methods:
  • Reversion to Mean: Exit the trade when the price moves back towards the mean or reaches a predefined profit target.
  • Trend Indicators: Look for signs that the mean reversion is losing strength, such as changes in trend indicators or decreasing volatility.

7. Review and Analyze

• Objective: Assess the performance of the strategy and make improvements.
• Methods:
  • Performance Metrics: Analyze results such as return on investment (ROI), win/loss ratio, and average gain/loss.
  • Trade Journal: Document trade details, including entry and exit points, reasons for trades, and outcomes, to refine the strategy.