Mean Revision Strategies

The theory behind mean revision strategies is that there exists a center of gravity around which prices fluctuate and it is possible to identify both this center of gravity and what fluctuation is sufficient to warrant putting on a trade. As with trend following there is also the economic rationale behind these movements. One reason could be due to short-term imbalances among the buyers and sellers due to liquidity that can make something overbought or sold.

An example of this could be, within a stock trading setting, that a company is about to get added to one of the major indexes and another company is dropping out of this index. As many funds track the index, it leads to buying in the one added and selling in the one which is being dropped. Because so many traders need to buy you will get a sudden increase in price as there are suddenly not enough sellers to match the buyers. Due to the sudden increase, there is an increased probability that the price will reverse again once the excess demand from the new index buys has subsided.

Another reason for this would be due to the behavior of market participants. Each will not be aware of other views and actions in the market and as trades are placed and the price moves towards the new equilibrium level. When this happens there is a tendency to overshoot due to excess supply and demand at any given time.


Sentiment Strategies

Sentiment strategies look at what market participants think what the price will do in the future using which can be done by looking at the options market. There are two ways to do this which we will explore below

One method is to look at the volume of puts and calls in the market and use this the sentiment indicator. If the puts on any pair have higher volumes relative to calls, it can indicate that investors are predicting a drop in the rate. If the puts have lower volumes, then it would be a bullish indicator and would mean that the rate is likely to rise.

Another method of options base sentiment uses the implied volatility for puts against calls. In equity markets, you will need to take into account that when the price moves up it is done at a slower pace than when the market declines which can skew the data. For FX there is less to take into account.

Sentiment strategies can also include the technical strategies analyzing trading volume, open interest or other similar types of data points. If you are trading on a short-term basis such as HFT they will use the order book to determine the near-term sentiment. The order book contains all the BID and ASKs currently in the market, the price level, and the volume. From this information, you can see if there are a large order in the market or whether there are more buys than sellers. For longer term strategies you may want to move away from the volume on the order book and look at the previous volume traded and turnover.

mean revision and sentiment strategies