What are the common risks and challenges of mean reversion strategy?

2 Managing risk and reward

Another challenge of mean reversion strategy is managing the risk and reward ratio of your trades. Since mean reversion strategy involves trading against the prevailing trend, you may face strong resistance and volatility from the market, and your trades may take longer to reach your profit targets or hit your stop losses. Therefore, you need to have a clear plan for your entry and exit points, and use appropriate position sizing and risk management techniques to protect your capital and maximize your returns. You also need to be aware of the potential market events and news that can affect your trades, and be ready to adjust your strategy accordingly.

3 Dealing with market regimes

A third challenge of mean reversion strategy is dealing with different market regimes and cycles. Mean reversion strategy works best when the market is range-bound or oscillating between support and resistance levels, and when the price movements are relatively smooth and consistent. However, when the market is trending strongly or experiencing sudden spikes or crashes, mean reversion strategy can fail miserably and result in large losses. Therefore, you need to be able to identify the dominant market regime and adapt your strategy accordingly. You can use trend indicators, such as moving averages or trend lines, to determine the direction and strength of the market, and avoid trading against the trend when it is too strong or unpredictable.

4 Balancing frequency and quality

A final challenge of mean reversion strategy is balancing the frequency and quality of your trades. Since mean reversion strategy relies on finding short-term price anomalies and reversals, you may be tempted to trade too often and chase every signal that appears on your chart. However, this can lead to overtrading, which can reduce your profitability and increase your stress and fatigue. On the other hand, if you trade too infrequently and wait for the perfect conditions and signals, you may miss out on many opportunities and reduce your trading edge. Therefore, you need to find a balance between frequency and quality, and focus on the most reliable and profitable signals that match your trading style and goals.