Are divergences mean reversion trades? Any tips on how to approach a mean reversion trade setup?
No idea about reversion trades; I also want to know details about this setup!
In one sense, yes: divergences are an example of the principle of “mean reversion”.
But although true, this is a bad way to look at it, as it confuses two different things, both of which you need to understand clearly, and separately, before moving on to your second question.
Divergences are disparities between the peaks and troughs of an indicator and the peaks and troughs of the price movements. For example, if the price makes a new higher high, but the 25-period RSI at the same moment shows only a lower high, a follower of divergences would expect the price’s new higher high not to last, and would be looking for opportunities to enter a short trade (sometimes rightly, too).
That’s partly on the principle that the RSI is an oscillator, and must at some point revert to its mean.
That doesn’t mean the price will necessarily go with it.
These sorts of divergences apply to things measured as oscillators, and things measured in standard deviations, and so on: things that mathematically have to “normalise” eventually.
The important point that most people misunderstand (especially on websites and in forums!) is that the price can “revert” to an indicator’s mean while moving the opposite way from what you’d expect.
If that sounds confusing, I’ll give you a typical example: when the price touches the top band of the Bollinger Band indicator, at some point it must “revert” to the midline. Sometimes by moving “back down” and sometimes by continuing to rise while the BB indicator rises more to catch up with it (in this case simply because that’s how moving averages work, and BBs are based on moving averages).
Then the result is that the price was on the indicator’s top line, and is now on its mideline (having “reverted”) because the indicator’s midline is now HIGHER than its top line was earlier on.
So the price has gone up, and in the process “reverted” from the upper extreme to the mean of the indicator.
That’s a very typical example of why this set-up is so often a bad idea.
People who’d advise you to identify and trade these usually don’t understand the subject too clearly themselves.
And there are hundreds of them.
Especially in forums.
Yes - avoid it.
It’s based mostly on widespread misunderstandings (unless you learn about it from a proper textbook that explains in detail the mathematics of charting and trading - but those are pretty heavy going, unless you START with a really good level of working knowledge of statistics and probability in the first place.)
Mean reversion means price will eventually be exhausted and revert back to it average value.
In a trending market there is no mean. Or it is simply too far away. Takes a very very long time for price to revert back to the mean.
In a ranging market price zig zag across the mean, say over dozen of candlestick overlapping by more than 50% of each candlstick. Price almost cock sure crosses the mean value.
Conventional strategy would be to define trading range. Midpoint level of trading range would be the mean level. Buy low when price close to support or breaches it. Sell high when price close to resistance or breaches it. On a smaller timeframe, extremely tough to execute because price movement can sometime be very fast and spread is too wide, perhaps automated advisor may work if the strategy is well programmed. For manual entry, financial time cycle and price data statistical information need to be collected and well back tested before execution.
Price almost always do a mean reversion after breakout. Mean level can be fibonacci level 38.2 50 and 61.8 retracement level. Averaging need to be incorporated for a better result. Last but not least Good money management need to be well crafted and strictly adhered to as well.
Sound logical and simple so far? i bet only 1 in a thousand would be able to execute it. Trading is never a walk in the park, its more like threading on thin ice. Give up and forget about trading. Its too damn hard.
I may be totally wrong
but I believe mean reversion simply means
look you have a moving average right
the moving average is literally that. a compiled average of the last whatever number of bars you set it to. this is your mean
if the price goes far away from the average, the typical expectation is that this is not normal according to the average. in other words, the price is out of line.
so then traders take trades to “ride” the price back to where the average is met again. aka back to the moving average
John from NYC
You’re not quite totally wrong, in that the one example you’ve mentioned is actually as an example of reversion, but it certainly isn’t “what reversion means”, which has already been very well explained above. Mostly, you’re just missing the point.
Aside from the great answers offered so far, I would like to add the following;
When price breaks quickly away from the moving average (let’s say the 20 EMA), it creates a moving average gap, or a space between the moving average and the closing price. Since the market is constantly trying to get back to equilibrium, the moving average and current price are drawn to each other like magnets. Price is always trying to get back to the moving average, and conversely, the moving average is trying to get back to the current price level.
Mean reversion trading is a reversal strategy whereby you anticipate price “reverting” back to the moving average and beyond, hoping for follow through and momentum. This technique is not normally used by itself. It is most often combined to with other strategies like trend reversals, pin bars, etc. to form a confluence.
I do not use reversion for my trading as a stand-alone strategy. Often times the moving average will meet up with price again via a flag pattern, and then quickly resume the trend once there is a flag breakout.
Hope this helps.
That’s it. If people are not sure what it means, just check at Wikipedia.