Mean reversals and trend continuation strategies tend to be opposite sides of a spectrum. However, these two very different types of strategies may be traded in confluence with each other. This is possible whenever we are looking at a long-term trend and a short-term momentum signal. The strategy discussed below shows us an example of how we can trade trend continuation strategies with a mean reversal signal indicated on the short-term.
Guppy Multiple Moving Average Indicator
The Guppy Multiple Moving Average Indicator is a momentum indicator which was developed based on a trading concept introduced by Daryl Guppy, an Australian financial columnist, in his book, “Trading Tactics”. This indicator was intended to help traders identify the direction of the market trend as well as short-term momentums using a set of moving average lines.
The Guppy Multiple Moving Average (GMMA) indicator uses multiple Exponential Moving Average (EMA) lines to help traders decipher the general and short-term direction of the trend. It is composed of 12 EMA lines which are divided into two sets. The first set is composed of the 3, 5, 8, 10, 12 and 15-bar EMA lines. This set represents the short-term trend or momentum. The second set is composed of the 30, 35, 40, 45, 50 and 60-bar EMA lines. This second set represents the long-term trend direction. The faster EMA lines have a lime hue, while the slower EMA lines gravitate toward a violet-red hue.
The GMMA lines can be used to identify the general trend direction. This is based on how the moving average lines are generally stacked. The trend is bullish if the faster moving average lines are generally above the slower moving average lines, and bearish if the faster EMA lines are below the slower EMA lines. Price charts that have GMMA lines that tend to crisscross each other indicates a market that is ranging or has no clear trend direction.
This indicator can also be used to identify the cyclical accumulation and distribution, or contractions and expansions of the market. This can be observed by the tightening and expanding of the GMMA lines.
Stochastic Oscillator
The Stochastic Oscillator is also a momentum indicator which was developed by George C. Lane in the late 1950s. According to Lane, the Stochastic Oscillator does not follow price or volume, instead it follows the momentum of price. To do this, the Stochastic Oscillator uses a formula that shows the location of the closing price in relation to the recent highs and lows of the price range over a preset number of periods.
The Stochastic Oscillator presents momentum indications using two oscillating lines. The Main Line is drawn as a solid line, while the Signal Line is a dashed line. These two lines oscillate within a fixed range of 0 to 100. Momentum direction can be identified based on how the two lines overlap. Momentum is bullish whenever the Main Line is above the Signal Line. Inversely, the market momentum is bearish whenever the Main Line is below the Signal Line. Given this assumption, crossovers between the two lines may indicate a potential momentum reversal.
The said range also has markers at levels 20 and 80. These markers represent the oversold and overbought market levels. The market is oversold if the oscillator lines drop below 20 and is overbought if the oscillator lines breach above 80, both of which are prime conditions for a mean reversal. As such, crossovers between the Main Line and Signal Line which occur beyond these levels indicate a high probability mean reversal signal.
Trading Strategy Concept
Guppy MMA Stochastic Trend Pullback Forex Trading Strategy for MT5 is a trend following strategy which trades on deep pullbacks which temporarily cause an overbought or oversold market imbalance on the short-term.
The Guppy Multiple Moving Average lines are used as the basis for identifying the main trend direction based on whether the faster GMMA line set is above the slower GMMA line set or vice versa.
As soon as the trend direction is identified, we could then start observing for deep market pullbacks. Such deep market pullbacks would cause the slower GMMA line set to contract and even temporarily crossover. It should also cause the Stochastic Oscillator line to temporarily breach the 20 or 80 levels indicating an oversold or overbought market on the short-term.
Trade signals are generated as soon as the Stochastic Oscillator would crossover and the faster GMMA line set would start to expand in the direction of the trend.
Buy Trade Setup
Entry
- The faster GMMA line set should be above the slower GMMA line set.
- Price action should pullback causing the faster GMMA line set to contract.
- The Main Line of the Stochastic Oscillator should drop below 20.
- The Main Line of the Stochastic Oscillator should cross above the Signal Line.
- The faster GMMA lines should start to expand moving up.
- Open a buy order on the confluence of these signals.
Stop Loss
- Set the stop loss on the fractal below the entry candle.
Exit
- Allow the Stochastic Oscillator lines to swing above 80, then close the trade as soon as the Main Line starts to cross below the Signal Line.
Sell Trade Setup
Entry
- The faster GMMA line set should be below the slower GMMA line set.
- Price action should pullback causing the faster GMMA line set to contract.
- The Main Line of the Stochastic Oscillator should breach above 80.
- The Main Line of the Stochastic Oscillator should cross below the Signal Line.
- The faster GMMA lines should start to expand moving down.
- Open a sell order on the confluence of these signals.
Stop Loss
- Set the stop loss on the fractal above the entry candle.
Exit
- Allow the Stochastic Oscillator lines to swing below 20, then close the trade as soon as the Main Line starts to cross above the Signal Line.
Conclusion
The strategy discussed above can be an effective trend continuation strategy especially because it trades on the confluence of trend pullbacks and mean reversal signals. However, it may sometimes produce lagging signals which may cause traders to enter the market a little later than most price action traders. This can be used to practice how to trade on deep market pullbacks, but traders who could master price action-based pullbacks may graduate to using price action alone as soon as they gain confidence in observing market structures.
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