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Return To The Mean (Mean Reversion)
The question is which mean are we talking about here. The theory of the return to the mean (Mean Reversion) is very popular among technical traders. Like every other principle, it should not be taken at its face value because it has many implications.
Generally, the mean is an average. It is commonly referred to as the intrinsic fair value. However, what is fair to one may not be the same for another. Moreover, which fair value is one talking about?
Usually, a technical trader will use the moving average fifty as the mean or dynamic fair value. A Fibonacci trader may use the sweet spot zone as the mean. A chartist can use a trend line that forms the base of a rising channel or top of a declining channel. A similar approach may be used by a pitchfork tool trader. As one can see the return to mean principle (Mean Reversion) is widely used in conjunction with what one accepts as the mean.
Furthermore, a trader who is using the Bollinger bands will attribute the mean to the middle band.
From the perspective of a fundamental trader, the mean is the book value of the financial asset that one is trading. In that instance, the mean is a static price level.
In many cases, the valuation of a company is also very divisive because some may take into consideration the future earnings while another may not.
The question remains the same. Which mean is the price returning to?
Despite those differences, no market participants will deny that one can have a short, medium or long term view in the financial markets.
After many years trying to find a way to calculate short and long term means l finally nail it. I developed a formula to calculate two means.
The first is what I call the short term equilibrium price level. The second is the long term equilibrium price level. Apart from other means that people have work with, I noted that the short and long term equilibrium price levels make more sense.
Note that the formula to calculate the short and long term equilibrium price levels will stay in my proprietary trading toolbox. I will not share it today.
The return to the mean is the return (pullback or rally) to the fair or true value after a dispersion or deviation. That may be a pullback after an initial rally.
For example, most financial instruments pull back to the moving average fifty after the third Elliott wave or an extended bullish momentum. Another example is when the price rallied to a moving average after an initial bearish move. A rally or pullback to a moving average, trend line or specific key level can constitute a return to the mean (Mean Return).
The theory of the return to the mean (Mean Return) states that the price of all financial instruments often deviates from its core value (dispersion). Those deviations are caused by volatility, momentum, market sentiment and demand to sell or buy the asset. One could argue that there could be a short, medium and long term deviation.
A short deviation is likely to engender a return to the short term mean. For example, a technical trader will call it moving average twenty. The same is true for medium and long term deviation. Technical traders use MA 50 for the medium term mean and MA 200 for long term.
Things become a bit tricky when one understands that what is a short term for one is not the same for another. For example, for a long term investor a year may be a short term, three years as medium and ten years as a long term. A day is a long term time spam for a day trader.
Taking into consideration all those factors, it is difficult to talk about a return to the mean (Mean Return). It would be better to talk about the return to a mean. Not the mean because there are different types of means.
One can rationally accept that there are short, medium and long term means.
A mean is not always equal to a fair value or book value. In this context a mean is an interesting value or price level that attracts more buyers or sellers after an initial bullish or bearish price-action.
That phenomenon of the return to the mean ( in fact return to a mean) relates to the market principle of expansion and contraction. It is similar to the respiration.
Think of it as if the price-action is breathing out after breathing in (expansion or extension). The return to the mean (Mean Return) is also is retracement to a mean. For an Elliott wave trader, the return to the mean (Mean Return) is a correction. After the financial instrument deviates from its fair value, a correction causes it to return to a mean (Mean Return) or a temporary fair average price level.
It is true that the financial markets always correct themselves after a distortion (deviation). Those corrections often lead to multiple returns to a mean (Regression toward the mean).
A typical correction after a bullish trend can be a pullback to the moving average fifty then a bounce then a pullback again to the moving average hundred then a short rally then the last pullback to the moving average 200. The correction can end at the MA 100 or MA 200. Elliott wave traders understand that a correction can be complex sometimes.
I will be writing about how to trade the return to the mean (Regression toward the mean) another time. As a new trader, I was captivated by the subject of the return to the mean to the point where I thought that could be the missing puzzle that I was looking for. I had many unanswered questions that cause me to dig a little deeper. Finally, I was