Mean Reversion Indicators Why They Work

If trend following is such a successful methodology, how can indicators based on the exact opposite philosophy generate consistent profits? The simple answer is that mean reversion indicators, such as RSI and other oscillators, work because they capitalize on the market's tendency to overex-tend itself.

Whether the trend has matured and is approaching climactic reversal or is still in its infancy and simply correcting a temporarily overbought or oversold condition, the market has an uncanny knack for separating the less experienced from their money by exploiting their greed, lack of patience, and complacency.

Imagine speculators who saw the bull move early but allowed fear of losses to prevent them from buying the market. As the trend matures, their anxiety and regret magnify in lockstep with forfeited profits until they finally capitulate and buy at any price so that they can participate in this once-in-a-lifetime trend. Since the thought process that accompanied their ultimate trading decision was purely emotional and devoid of price risk management considerations, when the inevitable pullback or change in trend occurs, greed and hysteria quickly shift to panic and capitulation.

Although mean reversion indicators such as oscillators attempt to somehow quantify these unsustainable levels of market emotionalism, they cannot do so as systematically as experienced traders with a "feel" for market psychology. For example, some on-floor traders are so attuned to the order flow entering their pit that they can consistently fade unsustainable emotionalism before it ever matures into a blip on a technician's radar.1


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