Probably the most common ways traders trade a non-trending market is to trade mean reversal setups. The market would often change into overbought or oversold within the short-term even when the market has no clear trend direction. It also tends to maneuver in a cyclical manner oscillating up and down the worth chart. Some markets might be very unpredictable. Nonetheless, some markets and currency pairs might be predicted based on how the cyclical waves reverse as prices change into overbought or oversold within the short term. Overbought or oversold markets would reverse back to a median price. This known as a mean reversal. Nonetheless, it could also cyclically swing over to the alternative end of the spectrum, identical to a pendulum.
To trade mean reversals, traders must have an objective method for identifying overbought and oversold price levels. This fashion they might know if a mean reversal was more more likely to occur. Next, we might also must have a way to discover potential reversals within the short term.
This strategy makes use of the Bollinger Bands and a modified Stochastic Oscillator to discover overbought or oversold levels, in addition to potential mean reversal entry points based on a reliable candlestick pattern.
Bollinger Bands
The Bollinger Bands is a flexible technical indicator that might be used to assist traders discover, trends, volatility, momentum breakouts, in addition to mean reversals.
The Bollinger Bands consists of three lines. The center line is a Easy Moving Average (SMA) line normally preset at 20 bars. The outer lines are standard deviations based on price movements and volatility and are plotted above and below the center line.
For the reason that middle line of the Bollinger Bands relies on a moving average line, it could possibly be used to discover trend direction and bias. Price motion would typically stay on the upper half of the Bollinger Bands during an uptrend, and on the lower half of the Bollinger Bands during a downtrend.
The Bollinger Bands can be used to assist traders discover the volatility of the market since its outer lines are based on the volatility of price movements. The Bollinger Bands are inclined to expand during market expansion phases, and contract during market contraction phases.
It will possibly even be used to identify momentum breakout setups based on a powerful momentum candle breaking out of a good market contraction phase.
Nonetheless, its hottest use is as a basis for overbought and oversold markets that are vulnerable to mean reversals. The hot button is in how price motion forms because it touches the outer lines of the Bollinger Bands. The outer lines signify overbought and oversold price levels. Candlesticks are inclined to form patterns that indicate price rejection as candles touch the outer lines. This means a possible mean reversal coming from an overbought or oversold price level.
Engulfing Stochastic
Engulfing Stochastic is a custom technical indicator based on a modified Stochastic Oscillator.
The Stochastic Oscillator is a widely used technical indicator that is often used to discover overbought and oversold markets based on the short-term horizon. It plots two lines that oscillate throughout the range of zero to 100. Short-term reversals might be identified each time the 2 lines cross. It also has markers at levels 20 and 80. Lines dropping below 20 indicate an oversold market, while lines breaching above 80 indicate an overbought market. Crossovers of the Stochastic Oscillator lines occurring beyond the 20 to 80 range are considered high-probability mean reversal scenarios.
The Engulfing Stochastic indicator modifies the Stochastic Oscillator by adding a mechanism wherein the indicator would indicate a signal each time an engulfing pattern forms on the worth chart while the market is either overbought or oversold.
Engulfing candlestick patterns are patterns composed of two candles wherein the body of the second candle completely engulfs the primary candle. This signifies a powerful price rejection which caused the market to completely reverse on the prior bar.
Trading Strategy Concept
This trading strategy is a mean reversal trading strategy that trades on reversal signals coming from a confluence of overbought or oversold market levels using the Bollinger Bands and the Engulfing Stochastics Indicator.
The Bollinger Bands can be used as a dynamic support or resistance line using the outer lines as levels where price may reverse coming from overbought or oversold price levels. This relies on price candles showing signs of reversal coming from such overextended market levels. The actual pattern we might use could be the bullish and bearish engulfing patterns.
The Stochastic Oscillator component of the Engulfing Stochastics could be used to watch overbought and oversold price levels based on the lines breaching the 30 to 70 range. The Engulfing Stochastics signals is then used to substantiate the mean reversals from the Bollinger Bands outer lines.
Buy Trade Setup
Entry
- Price motion should touch or drop below the lower line of the Bollinger Bands.
- The Engulfing Oscillator lines needs to be below 20 indicating an oversold market.
- The Engulfing Oscillator should discover a bullish engulfing pattern and plot an arrow pointing up on while the lines are below 20.
- Enter a buy order on the confluence of those signals.
Stop Loss
- Set the stop loss below the bullish engulfing pattern.
Exit
- Close the trade as soon as price motion shows signs of reversal while it’s near the upper line of the Bollinger Bands.
Sell Trade Setup
Entry
- Price motion should touch or breach above the upper line of the Bollinger Bands.
- The Engulfing Oscillator lines needs to be above 80 indicating an overbought market.
- The Engulfing Oscillator should discover a bearish engulfing pattern and plot an arrow pointing down while the lines are above 80.
- Enter a sell order on the confluence of those signals.
Stop Loss
- Set the stop loss above the bearish engulfing pattern.
Exit
- Close the trade as soon as price motion shows signs of reversal while it’s near the upper line of the Bollinger Bands.
Conclusion
Mean reversal setups using the Bollinger Bands is a widely used mean reversal strategy. Nonetheless, these setups might be dangerous at times since a break outside of the Bollinger Bands may signify a momentum breakout.
This strategy stacks the possibilities in our favor by trading only when the Stochastic Oscillator indicates that the market is overbought or oversold and that the market is rejecting the extent beyond the Bollinger Bands range based on an engulfing candlestick pattern.
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