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Mean Reversion: A Guide to Market

Timing
Mean reversion is a mathematical theory that is often used in the financial
markets. It represents a markets tendency to move back to the average price
after an extended move. This can be an average price on a trading chart or
even the growth rate of a particular economy.

Speaking of timing, you may have heard the saying, timing is everything. It
applies to all things in life and trading is no exception. In fact, I would go as far
as to say that proper timing is essential if you intend to become a consistently
profitable Forex trader. After all, a market that was a buy yesterday could be
a sell today, and vice versa.
There are several ways that a price action trader can time a market. We can
use key levels, price action strategies and even breakouts from patterns.
But theres one more way to time a markets movements, and that is through
the use of mean reversion. How do we measure a markets mean or average
price, you ask? Through the use of moving averages.

Moving Average Basics

Before we get into the details of mean reversion, lets first cover the basics
of moving averages.
Just as the name implies, a moving average shows the average price over a
specified period. This could be 10 days or 10 minutes. A moving average is a
lagging indicator because its based on past prices.
Moving averages come in two basic forms the simply moving average
(SMA) and the exponential moving average (EMA). The simple moving
average uses a straight average of past prices, while the exponential moving
averages give greater weight to more recent prices

The most common use of moving averages is to help identify the start of a
new trend or even the strength of an existing trend. But that isnt how were
going to use them. Instead, were going to use moving averages in a much
more insightful way as a mean reversion tool.

Understanding Mean Reversion

At this point, it should be fairly obvious how a moving average, or moving
average combination can be used as a mean reversion tool. After all, they are
both based on averages.

To keep things simple, were going to break down the term, mean
reversion using the following two definitions:
Mean = Average price

Reversion = To return to

This way you know that when I refer to the mean, Im referring to the average
price. And when I refer to reversion, Im referring to the market returning to the
average price.
Easy enough, right?

That said, lets take a look at an illustration of mean reversion in action.

Mean Reversion and Moving Averages
The first thing we need to figure out is which moving averages we should use.
Those who are familiar with my style of trading know that I like to use the 10
and 20 exponential moving averages (EMAs). In addition to mean
reversion, I also use these two moving averages as dynamic support and
resistance.
Heres what the 10 and 20 EMAs look like on a price action chart.

The chart above shows the AUDUSD daily time frame with the 10 and 20
EMAs applied. Notice how the 10 EMA in red follows price action much closer
than the 20 EMA. This is because the 10 EMA is based on the previous 10
periods, or in this case days, while the 20 EMA is based on the previous 20
days.

Lets look at the same chart again, only this time, were going to view these
moving averages a bit differently.
This time, were using the area between the 10 and 20 EMAs as a zone to
indicate a reversion to the mean. This zone represents the average price as
the market trends up and again as it trends down.

Notice how the market finds support and resistance in this area within each
trend. This is how we can use the 10 and 20 exponential moving averages to
help find areas to look for buying and selling opportunities.

But theres another way we can use the concept of mean reversion to help
time our entries into the market. Its the opposite of the word, reversion.
Avoiding Overextensions
If a reversion is a market returning to the mean, then an overextension is the
complete opposite. It represents a market that has made an
extended move away from the mean and is, therefore, likely to revert back
to the mean.
Lets add overextensions to the same AUDUSD daily chart.

Dont worry, the chart above isnt nearly as confusing as it might seem at first.
All we did was add overextensions to illustrate the area at which the market
is most likely to revert back to the mean.
 Notice how the overextensions occur just before the market reverts back to
the mean. This is where the real advantage can be seen when using moving
averages as a mean reversion tool.

If the market strays too far from the moving averages, its generally best
to wait for a pullback to the mean before looking to buy or sell.

Mind the Variables

A question I get quite often is, how do I know when the market has reverted
far enough back to the average price? The answer to this question depends
on three variables.

1. The market

2. Time frame

3. Current conditions

Lets take a look at each of these variables in greater detail.

The Market
Were going to define the market as the currency pair, commodity, precious
metal, etc. that youre trading. Each market moves to its own music. In other
words, every market has its own distinct way of moving in and out of trends as
well as its ebb and flow within a trend.

No two markets are the same when it comes to mean price or how far a move
may extend itself away from the mean price. However, with the help of the 10
and 20 EMAs, its possible to identify this area in any market. Thats because
the moving averages adjust accordingly depending on the market theyve
been applied to.
Time Frame
The time frame is extremely important when it comes to mean reversion. Just
like various markets, each time frame has its own way of moving. In fact, I
have discovered over the years that the 10 and 20 exponential moving
averages work the best on the four hour and daily time frames.

Current Conditions
This is perhaps the most important of the three variables. The current market
conditions are what allows you to read into how the market might react to the
mean.

It should be noted that the study and application of mean reversion are
best suited to trending markets. So if a market is trading within a range or
even choppy, mean reversion wont be of much help.

Using Mean Reversion to Time Your Entries

All of this is great, but at the end of the day, its all about timing your entries
into the market. In fact, becoming a successful Forex trader is all about
timing. Market dynamics are constantly changing, so having a way to time
your entries is essential.

The 10 and 20 EMAs are well-suited for this job. They provide us with a way
to avoid overextensions and focus our attention where it belongs on
pullbacks to the mean price within a trend.

Lets take a look at how these two moving averages can help you time your
trades on a f
our-hour chart.

The USDZAR four hour chart above shows how the moving averages can be
used to help time our entries. We want to avoid buying or selling when the
market has made an extended move away from the moving averages, as
these overextensions can quickly result in a reversion to the mean.

At this point you may be asking yourself, but isnt this similar to dynamic
support and resistance?
The answer is, yes, its very similar. The main difference is that when studying
mean reversion, the goal is to avoid overextensions. In other words, buying
too high or selling too low. The goal of dynamic support and resistance is to
use the moving averages as extra confluence at value the area where a
market is most likely to continue in the direction of the trend.
Exceptions to the Rule
Like most things, the application of mean reversion has its exceptions. The
most obvious of these exceptions are those which have already been
mentioned. However, theyre worth mentioning again.

The study and application of mean reversion as a trading tool is best

suited to the four hour and daily time frames. That isnt to say that other
time frames dont have a mean, as they most certainly do. However, in my
experience, these two time frames are the most reliable when using mean
reversion to identify buying or selling opportunities. Therefore we can consider
any other time frame as an exception to the rule.
Another exception is a ranging market or one that is experiencing
considerable chop. In other words, no clear direction or trend. Remember
that the use of mean reversion as a trading tool/advantage is best used
within a trending market. This can be a short-term trend on the four-hour
chart or a longer-term trend on the daily chart. Either way, a clear directional
bias is needed to take full advantage of the use of mean reversion.

Runaway Markets
The last exception can be defined as runaway markets. Whats a runaway
market, you ask? Its a market that is experiencing extreme buying or selling
and is therefore not as likely to revert to the mean price within the standard
span of time.

Heres an example of a runaway market on the daily time frame.

You may be wondering why someone wouldnt want to buy during these
rallies as the moving averages separated. Its a legitimate inquiry, but one that
deserves more self-reflection than anything else. It all comes down to your
style of trading that is, your comfort level as a trader.

You could opt to be more of a swing trader, which involves looking for
reversions to the mean. Or perhaps youre interested in becoming more of a
position trader, in which case the two rallies above would certainly interest
you. I consider myself a short to mid-term swing trader. Its what works for me
and its what I teach in my price action course.
Regardless of which style you ultimately choose, its important to stick to
your trading plan. If it says to avoid overextensions using the 10 and 20
EMAs, then the two USDJPY rallies above should be avoided, at least on the
daily time frame.
Which brings me to the last point in todays lesson. Remember how I
mentioned that one of the variables is the time frame youre viewing?

Here is that same USDJPY 1,600 pip rally, only this time were looking at the
four-hour time frame.

Notice how the pair formed a bullish pin bar on a reversion to the mean. We
also had former trend line resistance now acting as support. This is a great
example of how you can use mean reversion, the pin bar trading
strategy, trend lines and momentum in your favor.
So which time frame is best? This again depends on how you choose to trade
and ultimately what your trading plan says. But theres no rule that says you
 cant drill down to the four-hour chart to look for opportunities if the daily chart
is showing a strong trend. In fact, I consider this the preferred way to trade
Forex price action.

Summary
I hope this lesson has presented you with a new way to use moving averages
as a mean reversion tool. Just remember to always use the techniques
discussed here in combination with other confluence factors to truly put the
odds in your favor.
To wrap things up, lets review some of the most important points from todays
lesson.

Mean reversion is a mathematical theory that is often used in the financial

markets

The term mean = average price while reversion = to return to

For traders, the term mean reversion involves the study and application of a
markets tendency to move back to the average price after an extended move

We can use the 10 and 20 exponential moving averages (EMAs) as a mean

reversion tool

The 10 and 20 EMAs work best on the four hour and daily time frames

If a market strays too far from the 10 and 20 exponential moving averages, its
generally best to wait for a pullback to the mean before looking for a buy or
sell signal

An overextension is the opposite of mean reversion it represents a market

that has made an extended move and is therefore likely to revert back to the
mean

There are three variables that affect mean reversions: the market, time frame
and current conditions
 The study and application of mean reversion can help you time your entries to
avoid overextensions

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