There are many professional traders who trade trend continuation setups based on a confluence of a trend and a mean reversal. Although these concepts seem like polar opposites, this scenario does exist quite abundantly during trending markets. This confluence of a trend and a mean reversal opportunity develops whenever price action pulls back significantly during a trending market.
This strategy is a simple trend continuation strategy which trades on such confluence of a trend and a mean reversal signal.
Fisher RVI Indicator
The Fisher RVI Indicator is a momentum-based oscillator which is derived from two oscillators – the Inverse Fisher Transform Indicator and the Relative Vigor Index (RVI). The Fisher Transform Indicator, developed by John Ehlers, although not perfect, is a very accurate technical indicator which points out trend and momentum direction, as well as the reversals in price swings. The RVI on the other hand is a relatively smoother momentum indicator which can detect shifts in the direction and strength of the market momentum. Combining these two individual indicators into one can be a very promising proposition.
The Fisher RVI Indicator plots two lines which oscillates within the range of -2.65 to 2.65. The red line, which is the faster line, is called the Fisher RVI line, while the blue line, which is the slower line, is its signal line pair. The signal line moves similar to the Fisher RVI line. The only difference is that it is shifted backwards. This makes it easier for users to identify whenever the Fisher RVI line is reversing, since the two lines would cross.
Crossovers between the two lines indicate a momentum reversal. A Fisher RVI line crossing above the signal line indicates a bullish momentum reversal, while a Fisher RVI line crossing below the signal line indicates a bearish momentum reversal.
The lines tend to flatten whenever it reaches -2.65 or 2.65. At -2.65, the market can be considered oversold on the short-term, while at 2.65, the market can be considered overbought on the short-term. Crossovers developing after the two lines have flattened out can be considered as a probable mean reversal signal.
50 Simple Moving Average
The 50-bar Simple Moving Average (SMA) line is generally regarded as one of the main indicators for identifying the mid-term trend direction. Seasoned retail and institutional traders often use the 50 SMA line to help them determine trend direction and bias, the potential pullback points of price action, as well as potential trend reversals.
One of the ways traders identify trend direction is based on where price action generally is in relation to the 50 SMA line. Price action which is consistently above the 50 SMA line is indicative of an uptrend market. On the other hand, price action which is consistently below the 50 SMA line is indicative of a downtrend market.
Another method is based on the slope of the 50 SMA line. Moving averages tend to move to the direction where price action is. As such, moving averages also tend to curl and slope in the direction where price action is. In effect, trend direction can also be identified based on the direction of the slope of a moving average line. In the case of the mid-term trend, traders often observe the direction of the slope of the 50 SMA line to identify the direction of the trend.
The 50 SMA line can also act as a dynamic area of support or resistance during trending markets. Price action would often pullback near the area of the 50 SMA line as it oscillates within a trend. However, it also often stops just around the area of the 50 SMA line before it bounces and pulses back in the direction of the trend.
Trading Strategy Concept
This trading strategy is based around the concept of trading the confluence of a trend pullback and a short-term mean reversal signal trading in the direction of the trend.
The 50 SMA line is used to determine the direction of the trend based both on the general location of price action in relation to the 50 SMA line, as well as the slope of the line. However, traders should also visually confirm if the market is indeed trending based on the characteristics and patterns of its price swings. We would then opt to trade only in the trend direction indicated by the 50 SMA line.
Aside from being a trend direction filter, the 50 SMA line is also used as an area where we would expect potential pullbacks.
As price pulls back near the 50 SMA line, momentum should also temporarily reverse. If the pullback is deep enough, the Fisher RVI Indicator would start to flatten out on the extremes of its range, indicating a potentially overbought or oversold market. The crossover after the flattening of the Fisher RVI lines would be our signal indicating the resumption of the momentum in the direction of the trend.
Buy Trade Setup
Entry
- Price action should generally be above the 50 SMA line.
- The 50 SMA line should slope up.
- Wait for price action to pullback near the 50 SMA line causing the Fisher RVI line to temporarily drop and flatten out on its lower extreme.
- A bullish momentum candle should form near the 50 SMA line.
- Open a buy order as soon as the Fisher RVI line crosses above its signal line.
Stop Loss
- Set the stop loss below the entry candle.
Exit
- Close the trade as soon as price action shows signs of a bearish reversal.
Sell Trade Setup
Entry
- Price action should generally be below the 50 SMA line.
- The 50 SMA line should slope down.
- Wait for price action to pullback near the 50 SMA line causing the Fisher RVI line to temporarily drop and flatten out on its upper extreme.
- A bearish momentum candle should form near the 50 SMA line.
- Open a sell order as soon as the Fisher RVI line crosses below its signal line.
Stop Loss
- Set the stop loss above the entry candle.
Exit
- Close the trade as soon as price action shows signs of a bullish reversal.
Conclusion
This strategy is especially effective when used in a trending market condition with decently wider price swings. This allows the Fisher RVI lines to detect mean reversal signals right after a pullback.
Although not perfect, this strategy does have the potential to produce a string of profitable trades with decent risk reward ratios whenever used in the right market condition.
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