Mean reversion assumes that when price moves unusually far from its average, it is more likely to come back towards it than to keep going. It is the opposite philosophy to trend following and works best in balanced, range-bound conditions.
Measuring 'too far'
- Distance from a moving average, measured in ATRs (for example more than 2 ATR from the 20 EMA).
- Bollinger Bands: price closing outside the outer band.
- RSI at extreme readings combined with a stalling candle.
- Distance from VWAP on intraday index charts.
Entry and exit
- Wait for a sign the move is stalling: a rejection wick or a reversal candle.
- Enter towards the average; stop beyond the extreme.
- Target the moving average or VWAP, not a full reversal.
The danger
Strong trends can stay overextended for a long time. Mean reversion in a trending market is 'catching a falling knife'. Use it only when the higher timeframe is ranging, keep size small and never remove the stop.