Chart of the Day: AAPL

Markets operate in two basic modes: mean reversion, in which large moves are quickly reversed, and range expansion, in which large moves lead to further moves in the same direction. Different asset classes tend toward one mode or the other (that’s something that is not acknowledged enough in the technical analysis literature), and stocks tend strongly toward mean reversion. In other words, all other things being equal, large moves in stocks tend to be reversed. You can buy dips and short spikes, though the actual application is a bit more complicated than that.

One of the most powerful things technical analysis can do is to set the context for market moves and to attempt to quantify the most likely emerging volatility environment. I said, “all other things being equal, large moves in stocks tend to be reversed”, but all other things are not equal. In this case, this large selloff comes after a period of consolidation (volatility contraction) which set the stage for a directional move. Under these conditions, there is more likely to be further downside than a quick reversal. In other words, the bears are probably fully in control of this broken market leader, and look out below.

How you trade this pattern is another question, and there are a few answers. At this point, understand the context, and keep this point firmly in mind: we’ve only identified a pattern that provides a slight tilt to the probabilities. This is all that is possible. We deal in probabilities, not certainties, and any of a thousand things can cause a pattern to fail. Even though this pattern points down, can Apple explode into a rally? Sure, anything is possible, and your risk management plan must have contingencies for every possibility. Do not be surprised and caught off guard when a market does something other than what you expect.


Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.

This Post Has 2 Comments

  1. Markus

    Adam, you say stocks are more prone to mean reversal and we know commodities tend to trend. But what about equity index futures like the ES? Are they more likely to reverse to the mean like their underlying? And does the 2 modes also depend on the timeframe you watch?

    Thanks for a reply,

  2. Alex

    Hi Adam, just to tell you I have bought and read your book. It was by chance that I was browsing in the bookstore and chanced upon your book. Just by scanning through initially, I knew your book was very different from a lot of TA/trading books that are in the market.

    I have read more than 100+ investing/trading books and sad to say too many of them are standard regurgitated materials . Your book is one of the best that I have came across in recent times. I was blown away by the information inside your book. Brought my trading skills and thinking to a new level. Still got much to learn from you! Thanks.

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