Using Mean Reverting Indicators

How to Trade When Markets Move too Far

Bubble Burst
A Rertracement Can Be Like A Bubble Popping. Jason Way Photography | Getty Images

Talking Points:

  • Overbought/Oversold
  • Bullish & Bearish Divergence

Indicators can be incredibly helpful to traders wanting assistance in identifying trading opportunities. Trend following indicators such as moving average and the Ichimokucloud are understandably the preferred and trending environments, but some traders prefer a different approach to trading. The different approach is known as mean reverting or reversion to the mean whereas market prices are seen as a rubber band around a core line such that if the band moves too far away from the core, it will often snap back aggressively.

These snapbacks to an appropriate price have their time and place like all indicators. However, it is important that you know when these should be left off the charts. Let’s take a look at different types of extremes in the market the traders look to find so they can enter and hope of a snapback. The three types we will be looking at are overbought and oversold, bullish and bearish divergence, excessive optimism and pessimism.

Overbought/Oversold

When traders refer to overbought or oversold, they’re often referring to how an oscillator is performing on a chart. An oscillator tool helps you show if a specific currency pair is continuing to close near the top of the multi-period range or near the bottom of its multi-period range.

A popular oscillator is the Relative Strength Index created by Welles Wilder. Mr. Wilder noted that one could likely trade just RSI and end up being profitable, but I will leave the ability to prove that to those who follow his analysis.

The oscillators seen below the chart price and the line that makes up the RSI travels between zero and 100. Levels between 70 and 100 are seen as aggressively overbought markets whereas levels between 32 zero are seen as aggressively oversold markets.

As you can imagine, this flies in the face of trend following because it is asking you to sell on a bullish breakout and by on a bearish breakout.

However, the sweet spot is when a clean downtrend is emerged in the market is overbought in such a way that rejoining the larger trend is, the higher probability play. Put another way, when trading this manner, you should be looking for extremes against the trend to join the trend whereas an uptrend has you focusing on oversold signals to buy in the direction of the larger trend and a downtrend has you focusing on overbought signals to sell in the direction of the larger trend.

Bullish & Bearish Divergence

Divergence happens when price and momentum are not in sync. Experienced traders have referred to momentum as the only leading indicator. Momentum is derived from the field of physics explaining the force behind something emotion. Traders are looking to see whether the price is moving higher on weaker and weaker momentum or prices moving lower after an extended period of weaker and weaker momentum for the possibility of a mean reversion opportunity.

When momentum slows down against a larger move higher or lower, the subsequent break against the trend can be very aggressive, and that’s what traders are looking to trade. The frustration comes when momentum stalls for long periods of time without a break leaving traders wondering if there is a move at all at hand.

One example comes from the S&P 500 where momentum has been slowing down, but the price continues to flirt within a few percentage points of all-time highs. There are many mean reverting traders looking at markets like this for an opportunity to catch that first aggressive move toward an average level or price.

Whether or not divergence is bullish or bearish depends on what the market has been doing before the momentum. Bullish divergence happens when price continues to move lower after an extended period but momentum, as seen via an oscillator like RSI, starts to move higher. This is often a signal to traders that the old move is done and a kickoff against the prior trend is about to happen. Regardless of trading bullish or bearish divergence, traders should continue to expect around a 40% win rate or less with a strong risk to reward ratio because this approach fights strong moves and is in the S and P 500 trader will tell you, recognizing the set up isn’t as difficult as timing the right trade.

Conclusion

We have discussed what types of traders look to mean reversion tools and how even trend traders can benefit from this approach. Oscillators like RSI help traders to decipher overbought or oversold levels as well as bullish and bearish divergence. Naturally, you will likely see setups that do not work out but if risk as it is managed and you continue to cut losses short, these approaches to the markets can be very helpful.