3 Mean Reversion Strategies That Prop Traders Use To Trade For A Living

Curious about what strategies prop traders use in prop firms?

Then you want to consider using mean reversion strategies because that’s what many prop firms teach their traders to use.

But is it suitable for you?

It’s common knowledge that the market moves sideways more than 70% of the time.

That means that only about 30% of the time the market is trending either up or down.

I’m sure you’ve heard of this phrase before:

“The trend is your friend until it ends”

When the market trends, no matter what trend strategy you have, it will work.

Be it a breakout strategy…

A retracement or pullback strategy…

Or any strategy that lets you get into a trade in the direction of the trend…

As long as the market is trending, it will make money.

But what happens when the market moves sideways?

That’s when trend traders get tested mentally and emotionally when they get stopped out trade after trade.

So what can you do about that?

The answer is…

Add a mean reversion strategy to your trading arsenal.

What Is Mean Reversion?

There are many different types of strategies to trade the market.

But we can classify all strategies to 2 big categories:

• Trading with the trend (trend trading)
• Trading against the trend (counter-trend trading)

Mean Reversion classifies under the second category of trading against the trend.

How it works is that when the market moves away from the mean by a certain value as depicted by the trader’s methodology, he will enter a trade in speculation that it will revert back to the mean.

The idea of mean reversion strategies is that when the market deviates too far from their mean, they will revert.

Using Bollinger Bands

Let’s take a look at a simple example here to illustrate what I mean:

One popular indicator that is used by many mean reverting strategies is the Bollinger Band.

What the Bollinger Band is an indicator to mark the volatility of the market using “bands”.

The default settings of the bands are usually 2 standard deviations away from the mean.

And the mean is the moving average (20 Simple Moving Average is the default).

The moving average calculates the average price of the past number of bars (determined by the trader’s parameters) and marks where the average is on the chart with a line.

And the way many traders use Bollinger Bands is that if the market moves out of these bands, it’s considered to have moved too far out and it should revert back to the mean (the 20 SMA).

So what traders will do is go Short when the market goes above these bands, and go Long when the market goes below them.

Now, before you get excited and start selling all your belongings to bet all your money trading this strategy, be warned…

Because to trade this strategy profitably isn’t as simple as it seems.

When the market breaks above or below these bands, it could be an indication of a trend forming.

And if you’re just simply entering a trade each time the market goes out of these bands, you will get killed.

With that said, the principles of mean reversion strategies are simple…

Go Long when the market deviates by a certain value below the mean.

Go Short when the market deviates by a certain value above the mean.

Take profit at either the mean (indicated by the moving average) or at the other side of the band.

Stop Loss can either be at the previous swing high/low, or a certain multiple of the Average True Range (ATR).

Why Use A Mean Reversion Strategy?

I’m sure you’ve always heard that you should always trade with the trend.

But it’s not as easy as it sounds.

If it were that easy, no one would lose money.

Everyone would be multi-millionaires.

Heck, everyone would even be billionaires.

But that’s a pipe dream.

Interestingly enough, during the 4+ years that I was a prop trader, we weren’t taught any trend trading strategies by the prop firm.

In fact, our strategies were counter-trend by nature.

When I was at the equities desk, we were trading every bid and offer.

We traded like market makers scalping one tick at a time.

Meaning to say that we were always trading against the direction of the market.

So if the market were to make a sudden move against our bids or offers, we would be heavily caught in our positions.

Hence we had to constantly be alert and at our desk all the time.

Even if we had to go to the toilet, we would have to inform our trading buddy to watch over our orders while we dash to the toilet!

Also, when I was at the futures desk, we were trading spread strategies which are mean reversion by nature.

So the point I’m trying to make is that if professional traders in prop firms (who make a living trading the markets) trade mean reversion strategies, then there certainly is some merit in trading them.

When to Use A Mean Reversion Strategy

Some traders use a mean reversion strategy as their main bread and butter trading strategy.

While some traders complement it with their trend trading strategy.

What’s important is that you find one strategy that works for you.

Unlike prop traders, you have the liberty and discretion to trade how often you like and hold the trade for however long your strategy depicts it to be.

Prop traders are only allowed to trade intraday and must close out all their positions before they leave their desks.

That means no overnight positions are allowed.

So when is the best time to use a mean reversion strategy?

It’s when the market isn’t trending.

How do you tell whether a market is trending or not?

A simple way is to plot two moving averages on your chart.

I use the 20 EMA and 50 EMA.

Then what you want to see is whether the moving averages are crossing each other frequently.

If they are, then the market is most likely moving sideways.

Another way is to see if the market is making higher highs and higher lows, or lower highs and lower lows.

For a trend to happen, the market must move in either fashion.

If the market is forming higher highs and higher lows, then it could be the start of an uptrend.

And if the market is forming lower highs and lower lows, then it could be the start of a downtrend.

Alright, let’s get to the actual strategies that prop traders use in prop firms to trade the markets.

Mean Reversion Strategy #1: Jobbing

This was the strategy I used when I was an equities prop trader and it’s extremely profitable.

This strategy is used on penny stocks and we would place our orders on all the bids and offers to about 6 levels deep on each side.

So if the stock was $1.00 bid and $1.01 offer, we would have orders on the bid side from $1.00 down to $0.95, and we would have orders on the offer side from $1.01 up to $1.06.

This is how it would look like:

How It Works

The idea of this trading strategy is to scalp the market for one tick at a time.

That means if I get filled at $1.00, I will get out at $1.01.

Since I already have an order at $1.01, I can quickly close my trade for a profit if I’m at the front of the queue.

In case you’re wondering what I mean by “queue”, it means that your orders are being placed in the market based on the time you put it in.

For example, at $1.01 you can see that the total orders there are 1,800,000.

That means there’s a total of 1.8 million shares waiting to be sold at that level.

Since my order is 50,000 shares, my order is included in the 1.8 million shares you see on the order book.

But just from seeing this 1,800,000 shares order, I have no idea if I’m at the front of the queue or the back of the queue.

The advantage comes from being at the front of the queue because it means that if there is anyone that is lifting the offer (meaning buying the inside offer), I would be the first to get filled.

But if I’m at the back of the queue, I’d have to wait for everyone else to get filled before it’s my turn.

And a lot of the time, the market might just take out half of the orders at that level, and then reverse back down.

Which means to say, I missed my chance to take profit and may have to scratch my trade at $1.00 (meaning to breakeven on my trade).

Sometimes if the market moves too quickly and I get caught a few levels, depending on the market condition and how the order flow is like, I might hold on to my positions to the level above my first order.

So let’s say the market suddenly moves down 3 ticks at one go, I would be Long $1.00, $0.99 and $0.98.

And I may hold all my positions and get out at $1.01 for a big win.

Hence, this strategy can be considered a mean reversion strategy.

Now, you may think that scalping the market for one cent at a time is small money.

After all, how much can you make with just a one-cent move?

Well, a one-cent move could mean $500 to $1,000 because of the size of our positions.

Each time we enter the market, our orders can be as much as 50,000 to 100,000 shares.

Some of the biggest traders would be in 100,000 shares or more at EACH level on the bid and offer.

So in the example above, by holding on to 3 levels of bids at 100,000 shares each and then getting out at $1.01 is $6,000 in profit.

And that’s just for ONE stock.

At any given time, we have orders on 20 – 30 stocks.

Some gung-ho traders have more.

So you can imagine how stressful it is to monitor that many stocks with multiple orders on the bid and offers of each stock!

Because of this, whenever nature called, we had to literally sprint to the toilet.

And good luck to you if you have to go to the toilet for your “big business”.

But of course, you would have to pull several levels away from the inside bid and offer (first level of bid and offer) if you have to go to the toilet for some time.

While this is a very profitable strategy, unfortunately, it’s not very feasible to implement it as a retail trader.

And the reason is that you need a custom platform to trade this strategy (the trading platform was programmed by the prop firm)…

You also need to have very low commission rates to make this strategy viable because you will be making many trades in a day…

And you need a HUGE amount of capital to get started.

I’m talking about at least a couple of million dollars.

Unless you’re able to have all that, the best way to trade this strategy is to join a prop firm.

Mean Reversion Strategy #2: Spread Trading

This was a strategy I used when I was at the futures desk trading treasury futures.

The idea of spread trading is simple but not necessarily easy to execute.

This strategy involves trading two highly correlated pairs.

At my prop firm, it was mostly the Australian 10-year bonds against the US 10-year bond.

We would plot the Australian 10-year bond against the US 10-year treasury note based on a certain calculation to calculate the hedge ratios and derive a standardized format to chart the spread.

This would be adjusted from time to time by the prop firm and us traders would update it according to the new values.

How It Works

How the strategy works is that if the spread were to tear away by a certain amount of basis points, we would go Long one and Short the other.

The execution can be tricky to get perfect because we want to enter into the slower moving instrument first, and then try and get a good fill in the faster moving instrument after that.

And then we would wait till the spread reverts to the mean and close out our trades.

The other tricky part of this strategy is knowing when to cut when the spread doesn’t revert and continues to tear.

This is where a trader can wipe out all his profits made for the month if he gets too aggressive and continues to not just hold on to their position, but also adds on to their position.

It’s pretty much like if the market is crashing, you continue to buy and buy as it goes lower until you run out of capital.

In spread trading, this is pretty much the same.

Because this is a mean reversion strategy, traders have a view that the more the spread tears, the higher the chances that the spread will revert to the mean.

Now, of course, we were taught to cut our positions if the spread tears too much…

But it ultimately comes down to the discretion of the trader as to when “too much” is too much.

Hence, while this can be a profitable strategy, it can be difficult to execute and implement.

Mean Reversion Strategy #3: Pivot Points

The last mean reversion strategy is used by a friend who is in a prop firm trading forex.

I strongly believe that if you want to get into a prop firm, get into one that trades forex.

Because even if you leave the prop firm in the future, you can still trade it on your own at home.

Unlike the first two strategies I shared above, you would need a prop firm to execute them.

Now, this third mean reversion strategy involves using pivot points.

How It Works

Pivot points are levels where the market might potentially reverse at.

They are derived from calculating the previous day’s high, low, open and close.

That means each day you will have different pivot levels.

And luckily for us, there’s no need to manually calculate these levels because most trading platforms have it by default.

You can see from this chart below that there are a few places where the market reaches the pivot point levels and then reverse:

If you noticed in the chart above, there are many different pivot point levels.

You have the support levels from S1 – S3…

You have the resistance levels from R1 – R3…

And you have the mean which is P.

The idea behind this mean reversion strategy is to wait for the market to reach either of these pivot point levels…

And then see the price action to determine if there’s an entry or not.

So what kind of price action do traders look out for?

It can be looking for certain candlestick patterns…

It can be looking for divergence…

It can be looking for a certain chart pattern…

Or it can be a combination of the above.

The beauty of this strategy is that you do not need a prop firm to trade this strategy.

Of the 3 mean reversion strategies, this is probably the best strategy to use as a retail trader because no complex software or calculation is needed.

All you need is a good broker that has the MT4 trading platform…

Load the pivot point indicator…

Learn to read price action…

And you’re good to go.

In Summary

Now that I’ve shared with you the 3 mean reversion strategies that prop traders use to trade for a living…

Did that make you want to use a mean reversion strategy too?

Out of the 3 strategies that I’ve shared, only the last strategy is viable for a retail trader to trade from home.

If you want to trade the first two strategies, it would be better to get into a prop firm to trade them.

Because through a prop firm, you would have access to really low commissions since they make lots of trades.

And you can also get access to the tools and software needed to trade the strategies profitably.

Also, do note that these 3 strategies are meant to be traded intraday.

That’s what prop firms want their traders to do.

And because prop traders trade full-time, they can stare at the screen all day long.

That’s their job.

But if you have a full-time job, then it might be better to trade strategies that do not require much screen time.

And it doesn’t mean that if you don’t trade intraday you won’t be profitable…

Because you certainly can be profitable even if you do swing trading.

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