- May 2, 2022
- Posted by: CoachShane
- Category: Trading Article
Mean reversion is a statistical phenomenon in the market where large moves in price tend to reverse, to some extent, towards an average price. Price will move with momentum in one direction showing an imbalance, become extended, and then mean reversion becomes the leader in the imbalance.
When these two forces in the market are in balance, we will see a trading range begin. Any of you that have been chopped up in an instrument that is in equilibrium, you know how painful that can be.
Therefore, looking to trade an instrument where there is an imbalance with either momentum or the mean reversion tendency, is your best bet.
Going Against The Trend
Mean reversion is not to be confused with a true change in trend. After a momentum move in price, we generally will see some type of overextension in price. It is that overextension that results in reversion to the mean and, generally, a return to the trend direction after the reversal is complete.
This chart has a 48% increase in price with momentum over 13 trading days and is a prime candidate for mean reversion. A complex correction shapes up and price begins to chop around the 20 day simple moving average. Momentum steps in again and price is currently up 38% at the time of this screen capture.
Here is a daily chart of Apple showing not only momentum to the upside but also mean reversion.
While we know mean reversion is a natural part of the market, the actual average price it will return to is not always known. There are best guess estimates using a variety of tools but the fact is, we never know for sure.
But knowing the price is not the point. We aren’t looking for homerun hits trading against the trend with a reversion to the mean.
Failure To Continue
While it is true that mean reversion is a force in the market, a market that is extended through momentum can work off that move in other ways.
One of the most common ways price will work off momentum is either failing into a trading range or setting up a bull flag continuation pattern. On the left, price mean reverted more than half of the 45% increase in price. Over on the right, we see a bull flag and with the last one, we see a trading range form.
The takeaway is that you don’t blindly trade a potential mean reversion just because the market had momentum. You need to see some type of reversal setting up to increase your odds.
Trading Mean Reversion
The trick is to decide what an overextended instrument looks like. Is it price being far from a moving average? If so, how far?
One of the best ways to determine if a market is extended and potentially a mean reversion play, is through the use of bands or channels.
Bollinger Bands are one method traders will use. When price is a certain standard deviations away from an average price, traders will look for a setup to position against.
When price is poking outside either the upper band or lower band, traders can consider that a potential mean reversion trade could be forming. In this example, if you would have shorted, it would have been a painful trade to sit through. This is why a setup is important.
Keltner Channels can also be used and is my favorite trading indicator. I am not a fan of the balloon effect of the Bollinger Bands and like the ATR feature of the Keltner. This is a 20 period channel set to a multiplier of 2.5.
You would treat the excursion beyond the channels the same way you would with the Bollinger or any other band.
Mean Reversion Setup
You’ve identified an extended instrument that has increased on momentum price movement. That is not enough of a standalone condition to have you pushing the trading buttons.
There are a few ways to look at trading this move and one of them is the 2B price pattern.
Price had run up 62% and broken the upper Keltner Channel. We can consider this the first part of our setup. Price has a small retracement, breaks the high and we see a reversal candlestick taking place. Traders would place a sell stop to enter short below the reversal candle. If price reverses and continues in the trend direction, we want out. Protective stop loss will be just beyond the high of the reversal.
Another example with the reversal candle being a bearish engulfing. The trade entry and protective stop loss is the same as the previous example.
If a trader is wanting the ideal setup for a mean reversion trade, it would look similar to this.
Price would run up with momentum (usually at the end of the move) and break the channels. We would see a slight pullback that put in new candle lows. The run up in price would take out the most recent high and then reverse.
While there may be other ways to trade an overextended instrument, the 2B (failure test) setup would be one of the better ways.
If we consider what price is showing:
+ Price runs up and breaks the channel/bands. Traders sitting on the sidelines are suffering FOMO from missing the first move
+ A slight retracement takes place bringing new longs into the action
+ Price makes a new high bringing breakout traders into the mix as well
+ Quick reversal has longs jumping into the exits while those that traded mean reversion, are quickly into profit.
For these trades, I would consider half my normal position size. Quite often, we will see another poke above (or below) as different time frames are reacting to the event. You would get stopped out on the first position but have another position waiting to be used if the setup presents again.
The biggest issue with traders jumping into extended moves because they are afraid of missing out, is mean reversion. A trader must understand the two forces that take place in the market and be able to identify them.
To scan for these types of events, a trader can use an oversold/overbought scan that can be found in any screener. To narrow down the selection, apply either Keltner Channels or Bollinger Bands with certain rules: a close beyond, a piercing of high/lows.
The 2B pattern described is a simple way to catch these moves but also to have you being aggressive in locking in profits during the trend move. If you are long and you see a mean reversion setting up, trade management is job number one for a trader.
There are different ways these overextensions will set up that would take a while to discuss. As you go through 100’s of charts to study these setups, you will find similarities between those the stalled and those that offered some good gains. Your job is to define your plan using what you learn during your study.