Mean Reversion vs. Mean Expansion: Which Approach Should You Use in Crypto Technical Analysis?
As the digital currency market continues to evolve, investors are faced with an increasingly complex landscape. Among the various analytical tools available, mean reversion and mean expansion are two approaches that are commonly used to forecast price movements in cryptocurrencies. But which one is more effective, and how can they be used in conjunction to improve forecasting accuracy?
The Fundamentals of Mean Reversion
Mean reversion is a concept that was first introduced by financial theorist Alfred Cowles in the 1930s. It suggests that asset prices tend to revert to their historical means over time, with extreme price movements being corrected by the underlying economic fundamentals. In other words, mean reversion is based on the idea that stock prices, for example, are not destined to remain at extreme levels, but will eventually return to their average or mean value.
In the context of crypto technical analysis, mean reversion is often used to identify overbought or oversold conditions in a cryptocurrency. This can be achieved by analyzing charts, identifying areas of resistance and support, and looking for signs of a potential break. If a cryptocurrency is overbought, for example, it may be due to a price surge caused by speculation. In this scenario, mean reversion would predict a correction back to its historical average price.
The Fundamentals of Mean Expansion
Mean expansion, on the other hand, is a more nuanced approach that suggests that asset prices may not always revert to their historical means. Instead, prices can continue to rise or fall, fueled by changes in the underlying economic fundamentals. This approach is based on the idea that financial markets are constantly evolving, and that changes in sentiment, investor behavior, or economic conditions can cause asset prices to deviate from their historical means.
In the context of crypto technical analysis, mean expansion can be used to identify areas where a cryptocurrency is likely to continue its upward or downward trend. For example, if a cryptocurrency is exhibiting signs of strong demand, such as a rapid increase in trading volume, it may be due to a shift in sentiment or an increase in institutional investment. In this scenario, mean expansion would predict a continuation of the uptrend.
Which Approach Should You Use?
So, which approach should you use when analyzing cryptocurrencies? The answer is not straightforward, as both mean reversion and mean expansion have their own strengths and weaknesses.
Mean reversion is a more traditional approach that is based on historical data and economic fundamentals. It is often used by institutional investors and traders who are looking for a more conservative approach. Mean reversion can be effective in identifying overbought or oversold conditions, but it can be slow to react to changes in market sentiment.
Mean expansion, on the other hand, is a more speculative approach that is based on changes in market sentiment and investor behavior. It is often used by traders who are looking for a more aggressive strategy, and can be effective in identifying areas where a cryptocurrency is likely to continue its upward or downward trend. However, mean expansion can be more difficult to apply, as it requires a deep understanding of market psychology and sentiment.
Combining Both Approaches
So, how can you combine both approaches to improve forecasting accuracy? One approach is to use mean reversion to identify areas of potential reversal, and mean expansion to identify areas where a cryptocurrency is likely to continue its trend.
For example, if you are looking at a cryptocurrency that has been trending upwards, you may use mean reversion to identify areas of resistance and potential reversal. At the same time, you may use mean expansion to identify areas where the trend is likely to continue, such as a sharp increase in trading volume.
Real-World Examples
Let’s take a look at some real-world examples to see how mean reversion and mean expansion can be used in conjunction.
In January 2018, Bitcoin’s price surged to nearly $20,000, prompting many to predict a sharp correction. Mean reversion would have suggested a correction back to its historical mean, while mean expansion would have suggested a continuation of the uptrend. In this case, the correction was more severe than expected, and the price fell below $6,000 by December 2018.
In the summer of 2020, the price of Ethereum’s native cryptocurrency, Ether, began to rise rapidly, driven by increased demand from decentralized finance (DeFi) applications. Mean expansion would have suggested a continuation of the uptrend, while mean reversion would have suggested a correction. In this case, the price continued to rise, eventually reaching a new all-time high.
Conclusion
In conclusion, mean reversion and mean expansion are two powerful approaches that can be used in conjunction to improve forecasting accuracy in crypto technical analysis. Mean reversion is a more traditional approach that is based on historical data and economic fundamentals, while mean expansion is a more speculative approach that is based on changes in market sentiment and investor behavior.
By combining both approaches, traders and investors can gain a more complete understanding of a cryptocurrency’s price movement, and make more informed decisions. Whether you’re a seasoned trader or just starting out, understanding the difference between mean reversion and mean expansion is essential for navigating the complex and ever-changing world of cryptocurrencies.
[Note: This article is for educational purposes only and should not be considered as investment advice.]