I like getting questions that I can write blog posts about and this one comes from a long time reader.
Hi SD, Did you miss the USDCHF mean reversion setup this week or you did not think that it was going to yield more than 100 pips?
In short, the answer is no and no.
Mean reversion trades are essentially counter trend and those need specific criteria. While the chart may evolve into the natural rally in price, it does not mean that it can or should be traded.
All charts have multiple time frame influences and while on a daily chart I may not see something worth risking, a lower time frame may be showing something different.
Let’s get to the daily chart
Price has traveled a measured move from the upper consolidation and had some consecutive days of determined momentum to the downside bringing us to the last candle on the chart
- The first green circle is more indicative of the type of preceding price action that I want to see before taking a counter trend trade
- The second green circle shows the same type of candlestick without the preceding momentum price action
Why not trade the first green circle? It’s at a random location on the chart and I don’t trade individual candlestick patterns on their own.
Why not trade the second green circle? There is not momentum to the downside. The price action overall is not indicative of strong intent.
To trade a mean reversion trade that is not inside of a range (which I rarely trade), I need to see:
- An obvious over extension in the market – this wasn’t it
- An obvious price exhaustion – this wasn’t it
Any trade at this location off of this chart, by my eye and my approach, is a random trade that is not backed up by any type of logical theory.
This is a rough idea of what I like to see but you must understand what is happening – what do you think other traders are thinking – what has happened to those short?
(You should be asking yourself if this is the type of price action, the 2 red candles, that you want to see in a pullback)
As for potential profits, I don’t hold to the 100 pip potential at all. As I consider these counter trend and do anticipate another leg lower, I exit when price shows it has the potential to turn against me.
- Market that is showing itself to be stretched
- Momentum into the turn
- Strong rejection at some type of price structure
As a trader, you will have to determine how you see all three factors.
It takes me 10 seconds to determine if I am going to post a chart to the weekly setups. I know exactly what I want to see what I don’t want to see. You need to have your process down and consistent.
SD – thanks for the thorough explanation on when to take mean reversion trades with an edge.
I think the challenge is how to determine that the market is stretched – the other 2 momentum and price rejection are quite easy to see.
No problem. As for a stretched market, you can consider using a bollinger band or trend line channels. With that on the chart, it will frame price better and a stretched market should be easier to define.