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balance-scale[dc]C[/dc]ontinuing from my previous post, I wanted to look into the two forces in a little more depth. As a quick review, I suggested that mean reversion (the tendency for large movements to be reversed) and momentum (the tendency for large moves to lead to more movement in the same direction) were the two forces underlying all price action and all patterns in the market. These forces are usually in balance, so markets are usually in equilibrium and markets usually move more or less randomly, but there are points where we can identify patterns that show that one force or the other is likely to dominate over a certain timeframe. When we find these patterns, we have an edge and, possibly, a reason for being involved in a trade—this is a short summary of the entire problem of technically motivated trading, but the question is, what are those patterns?

Though far from a comprehensive list, here are some patterns that generally support once force dominating in the future. In a future post, I will share some quantitative tests and some specific structures/patterns that we can use to identify these spots in the market.

Mean Reversion

  • Fading large single bars
  • Fading a series of bars that have a large price change
  • Fading N-day runs. (E.g., shorting the close of the 5th upward close in a row.)
  • Fading N-day highs or lows. (Fading channel breakouts)
  • Fading large excursions from moving averages.

As you can see, the concept of “large” comes up again and again, so it is important to be able to identify these large, or outsized, moves in the market.

Momentum

  • Volatility compression
  • Pullbacks

In both cases, the concepts are simple. In mean reversion, we want to identify very large, extreme moves. To find places where momentum is likely to predominate we need to either identify an area where volatility is very compressed (more on how to measure that soon), or look for a large move, wait for mean reversion to set in (i.e., a pullback), and then enter in the direction of that large move.

There are many ways to structure and define these tendencies, but this is a very useful high-level overview. Start rethinking your trading and market patterns into these two large categories, and we will go into some examples and quantitative tests in future blog posts.