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Mean reversion is a mathematical theory that is often used in the financial markets. It represents a market’s 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.
But there’s one more way to time a market’s movements, and that is through the use of mean reversion. How do we measure a market’s mean or average price, you ask? Through the use of moving averages.
Before we get into the details of mean reversion, let’s 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 it’s 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 isn’t how we’re going to use them. Instead, we’re going to use moving averages in a much more insightful way – as a mean reversion tool.
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, we’re 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, I’m referring to the average price. And when I refer to reversion, I’m referring to the market returning to the average price.
Easy enough, right?
That said, let’s take a look at an illustration of mean reversion in action.
Notice in the illustration above, we have two elements at work. We have the mean and we have the reversion to that mean. This is the most basic form of mean reversion. Although the concept is easy to understand, I’m certain that what you’re about to learn will change the way you view the markets.
Now that you’re starting to grasp the idea of how moving averages can be used as a mean reversion tool, let’s dig in a little deeper to better understand the relationship between the two.
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.
Here’s 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.
Let’s look at the same chart again, only this time, we’re going to view these moving averages a bit differently.
This time, we’re 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 there’s another way we can use the concept of mean reversion to help time our entries into the market. It’s the opposite of the word, “reversion”.
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.
Let’s add overextensions to the same AUDUSD daily chart.
Don’t worry, the chart above isn’t 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, it’s generally best to wait for a pullback to the mean before looking to buy or sell.
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.
Let’s take a look at each of these variables in greater detail.
We’re going to define “the market” as the currency pair, commodity, precious metal, etc. that you’re 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, it’s possible to identify this area in any market. That’s because the moving averages adjust accordingly depending on the market they’ve been applied to.
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.
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 won’t be of much help.
All of this is great, but at the end of the day, it’s 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.
Let’s take a look at how these two moving averages can help you time your trades on a four-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 isn’t this similar to dynamic support and resistance?
The answer is, yes, it’s 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.
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, they’re 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 isn’t to say that other time frames don’t 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.
The last exception can be defined as “runaway markets”. What’s a runaway market, you ask? It’s 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.
Here’s an example of a runaway market on the daily time frame.
Notice in the USDJPY daily chart above, the market made two extended moves during which there was no reversion to the mean. In fact, the second rally totaled 1,600 pips. It’s rare for a market to move this distance without a pullback, however, it clearly can and does happen.
You may be wondering why someone wouldn’t want to buy during these rallies as the moving averages separated. It’s 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 you’re 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. It’s what works for me and it’s what I teach in my price action course.
Regardless of which style you ultimately choose, it’s 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 today’s lesson. Remember how I mentioned that one of the variables is the time frame you’re viewing?
Here is that same USDJPY 1,600 pip rally, only this time we’re 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 there’s no rule that says you can’t 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.
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, let’s review some of the most important points from today’s lesson.
What do you think about the use of mean reversion as a trading tool? Do you currently use something similar to avoid market overextensions?
Leave your feedback below. I look forward to hearing from you!
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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