TLDR: A 3-step simple strategy in using Bollinger Band, Relative Strength Index (RSI) and TradeDots Indicator conjunctively to explore the best buy/sell point on any trading asset

Mean reversion is a financial theory that suggests asset prices will naturally gravitate towards their average price over time. This strategy operates on the belief that prices fluctuate randomly around a stable trend, causing values that deviate significantly from the trend to eventually reverse direction and return to the mean.

In this blog, we will delve into how the concept of mean reversion can be utilized to generate profits during market overreactions. This strategy is easy, straightforward and can be applied to any type of asset.

To maximize the effectiveness of this strategy, it is recommended to utilize the TradeDots indicator, which can help identify optimal entry and exit prices. You could subscribe and try it out for free by clicking here.

3–Step Mean Reversion Strategies

In this strategy, we will employ the Bollinger band, Relative Strength Index (RSI), and TradeDots indicator to identify the most favorable entry and exit points. The first two indicators can be found on the TradingView indicator list, while the TradeDots indicator can be accessed for free through subscription.

Step 1: Identifying the Squeeze

First of all, we will need the Bollinger band indicator to identify assets that are trading within a narrow range between the upper and lower bands. This indicates low volatility and suggests that the asset is primed for a significant market movement in the near future.

For instance, if we examine the example of Palantir below, we can observe that the market price remained stable for an extended period, indicating an imminent surge in volatility. It looks perfect for us to enter.

This step is crucial because selecting an asset in a high volatility stage would make executing the strategy more challenging, as it would result in more false signals.

Step 2: Entering the Trade

Once assets with low volatility have been identified, the RSI and TradeDots indicator can be used to pinpoint an optimal entry point. For example, if the RSI is low and accompanied by a TradeDots red dot signal, it signifies that the asset is oversold and expected to revert in the subsequent bars, vice versa. It will give us a clear picture of when to buy or sell a position.

Looking at the same example on Palantir, we could observe that prior to the significant uptrend movement, there was a market divergence signal where the selling momentum decreased while the price continued to fall. This bullish signal indicates a resurgence in buying pressure. Combined with the TradeDots red reversal signal, which signifies a bullish price action pattern, this prompts us that it is the time to enter a long position.

Step 3: Determining the Exit with Mean Reversion Theory

It is important to note that after the asset experiences a surge following the squeeze, it will become overbought or oversold. This is when discipline comes into play, and we have to close our position once the asset reaches a reversal point.

To identify the optimal exit point, all three indicators must be used in conjunction. If the market price of an asset touches or surpasses one of the two Bollinger bands, it indicates an abnormal value that has a high chance to revert back to the mean level. To validate this decision, the RSI indicator can be used to confirm if momentum has reached an extreme level, and the TradeDots indicator can help identify the market reversal point for exit.

In the case of Palantir, the price exceeded the upper Bollinger band, with an RSI above 85, and a divergence signal was formed, which is a strong bearish signal. We then confirmed the sell point with TradeDots, as it displayed a green dot, indicating a high probability for the market to revert into a downtrend. Consequently, we closed our position after the TradeDots indicator confirmed the exit.

Limitations of Mean Reversion

While this set of strategies may appear simple to execute, it is not without its limitations. For instance, trading in lower timeframes exposes the price to unexpected events and market conditions, resulting in more noise and false market signals.

Additionally, when an asset is experiencing a clear uptrend or downtrend, it becomes challenging to trade against the trend, as the price may bounce before reaching the median line. This can lead to traders holding losing trades for extended periods.

Therefore, it is very important for traders to always implement stop loss and take profit strategies and acknowledge the unpredictable nature of market activity, as there are no guarantees in trading.

Bottom Line

In conclusion, mean reversion is a powerful trading theory that can be utilized to generate profits through three simple steps. Subscribe to TradeDots now to discover better market entry and exit prices. If you are interested in learning how to utilize TradeDots in different trading strategies, please read our TradeDots Tutorial Documents.

About TradeDots

TradeDots is a TradingView indicator that identifies market reversal patterns through the implementation of quantitative trading algorithm on price actions. Try our 7-day FREE Trial to level up your trading game.

Set up your personalized trading alerts using our Telegram Bot, so you can now trade effortlessly without gluing to your screen. Join us now to experience TradeDots across all trading assets!

—

Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial advice. Trading involves risk, and it is important to conduct thorough research and seek professional guidance before making any investment decisions. Prospective investors are encouraged to perform their own due diligence or consult a financial advisor before making investment decisions.