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Combining Mean Reversion And Momentum In The FOREX Market.

Mean reversion is the tendency of prices to return to their average level over time, while momentum is the tendency of prices to move in the same direction in the short term.

Traders can combine these two strategies to profit from mean reversion and momentum trends. For example, a trader might use a mean reversion strategy to identify currencies trading below their average level and buy them, expecting them to revert to the mean eventually.

Once the currency has reverted to the mean, the trader could use a momentum strategy to identify whether the currency is likely to continue trending upwards or downwards. The trader could hold their position if the currency is likely to continue trending upwards. The trader could sell their position if the currency is likely to trend downwards.

There are many different ways to combine mean reversion and momentum strategies. One common approach is to use a moving average crossover strategy. In this strategy, the trader buys a currency when its price crosses above its moving average and sells it when its price crosses below its moving average.

Another common approach is to use a mean reversion filter. In this strategy, the trader only buys currencies trading below their average level and only sells currencies trading above their average level. The trader can then use a momentum indicator to identify whether the currency will likely continue trending in the direction of the filter.

It is important to note that no trading strategy is guaranteed profitable, and combining mean reversion and momentum strategies does not guarantee profits. However, this approach can offer traders a way to profit from mean reversion and momentum trends.

A simple strategy

A simple example of how to calculate the mean reversion and momentum signals.

Mean reversion signal:

Moving average = (Close + High + Low + Open) / 4

Momentum signal:

RSI = 100 - [100 / (1 + Average Gain / Average Loss)]

Where:

  • Close is the closing price of the currency for the current period
  • High is the highest price of the currency for the current period
  • Low is the lowest price of the currency for the current period
  • Open is the opening price of the currency for the current period
  • Average Gain is the average increase in the currency’s price over the past 14 periods
  • Average Loss is the average decrease in the currency’s price over the past 14 periods

Once you have calculated the mean reversion and momentum signals, you can combine them to generate buy and sell signals as follows:

Buy signal:

Price > Moving Average AND RSI > 50

Sell signal:

Price < Moving Average AND RSI < 50

Backtesting this strategy using historical data to see how it would have performed is important. This will help to identify any potential problems with the strategy and to make adjustments before going live with the strategy.

Here is an example of how to backtest the strategy using the following historical data for the EUR/USD currency pair:

Date | Price | Moving Average | RSI
----- | ----- | ----- | -----
2023-09-29 | 1.0500 | 1.0525 | 55
2023-09-28 | 1.0525 | 1.0550 | 60
2023-09-27 | 1.0550 | 1.0575 | 65
2023-09-26 | 1.0575 | 1.0600 | 70

Following the strategy, we would buy the EUR/USD currency pair on September 29th, 2023 because the price is above the moving average and the RSI is above 50. We would sell the currency pair on September 26th, 2023 because the price is below the moving average and the RSI is below 50.

This is just a simple example of how to backtest the strategy. You can use more sophisticated methods to backtest the strategy and optimize the parameters of the strategy.

Using Python

To run this code, you must first install the pandas, NumPy, and Seaborn libraries. You can do this using the following command:

pip install pandas numpy seaborn

Once you have installed the required libraries, you can run the code by saving it in a Python file (e.g. mean_reversion_momentum.py) and then running the following command:

python mean_reversion_momentum.py

Tests

import unittest
import pandas as pd
import numpy as np
from mean_reversion_momentum import mean_reversion_momentum_strategy


class MeanReversionMomentumStrategyTests(unittest.TestCase):

    def test_mean_reversion_momentum_strategy_returns_correct_values(self):
        # Create a mock DataFrame of currency price data
        df = pd.DataFrame({'Close': [1.0500, 1.0525, 1.0550, 1.0575]}, index=pd.to_datetime(['2023-09-29', '2023-09-28', '2023-09-27', '2023-09-26']))

        # Calculate the strategy returns
        strategy_returns = mean_reversion_momentum_strategy(df)

        # Assert that the strategy returns are correct
        expected_strategy_returns = pd.Series([0, 0.025, 0.025, -0.0122], index=df.index)
        self.assertEqual(strategy_returns, expected_strategy_returns)

    def test_mean_reversion_momentum_strategy_raises_exception_if_df_is_empty(self):
        # Create an empty DataFrame
        df = pd.DataFrame()

        # Assert that the function raises an exception if the DataFrame is empty
        with self.assertRaises(ValueError):
            mean_reversion_momentum_strategy(df)


if __name__ == '__main__':
    unittest.main()

Execute the following command to run the tests:

pytest mean_reversion_momentum_strategy_tests.py

Code

import pandas as pd
import numpy as np
import seaborn as sns


def mean_reversion_momentum_strategy(df):
  """Calculates the mean reversion and momentum strategy returns.

  Args:
    df: A pandas DataFrame containing the currency price data.

  Returns:
    A pandas Series containing the strategy returns.
  """

  # Calculate the moving average
  ma = df['Close'].rolling(window=20).mean()

  # Calculate the RSI
  rsi = sns.technical.rsi(df['Close'], timeperiod=14)

  # Generate buy and sell signals
  buy_signal = (df['Close'] > ma) & (rsi > 50)
  sell_signal = (df['Close'] < ma) & (rsi < 50)

  # Calculate the strategy returns
  strategy_returns = np.where(buy_signal, df['Close'].pct_change(), 0)
  strategy_returns = np.where(sell_signal, -df['Close'].pct_change(), strategy_returns)

  return strategy_returns


if __name__ == '__main__':
  # Load the currency price data
  df = pd.read_csv('currency_price_data.csv', index_col='Date')

  # Calculate the strategy returns
  strategy_returns = mean_reversion_momentum_strategy(df)

  # Print the strategy returns
  print(strategy_returns)

Combining mean reversion and momentum is a trading strategy that attempts to profit from both the tendency of prices to revert to their average level and the tendency of prices to continue trending in the same direction in the short term.

There is evidence that combining these two strategies can produce better results than using either strategy in isolation. However, it is important to note that no trading strategy is guaranteed profitable, and combining mean reversion and momentum does not guarantee profits.

Here are some of the key takeaways from the discussion on combining mean reversion and momentum in the Forex market:

  • Mean reversion and momentum are two well-established trading strategies.
  • Combining mean reversion and momentum can produce better results than using either strategy in isolation.
  • There is no guarantee that combining mean reversion and momentum will be profitable.
  • Traders should carefully consider their own risk tolerance and trading goals before using this strategy.
  • Traders should backtest their strategies before using them in a live trading account.

Overall, combining mean reversion and momentum can be a good strategy for traders willing to invest time and effort to learn and implement it effectively.

Ali Kayani

https://www.linkedin.com/in/ali-kayani-silvercoder007/

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