Mean Reversion, “Natural levels”, and the Euro

• RemixTrades
• August 10th, 2010

As Reinhart and Rogoff explain in their book, This Time is Different: Eight Centuries of Financial Folly, most things in the financial world have not fundamentally changed over time. While the wording, technology, and erroneous reasoning have evolved, simple market dynamics have generally remained static.

In the last year, the Euro currency ($EURUSD) has definitely seen its ups and downs. As discussed in my last post (Euromesia: Decoupling is mainstream, again), the rhetoric on the single currency has swung back and forth from decoupling to collapse, with every market expert claiming that “this time is different.” After the recent 1.18-1.52 price volatility, the question becomes whether the 1.30 level (and the range of 1.28-1.34) is a reasonable place for the Euro to stabilize. Many experts believe the Euro is too ‘expensive’ at the current levels and has rallied as a result of being oversold.

Some simple arithmetic appears to tell a different tale. If you take the average of the Euro’s ($EURUSD) daily closing price back to August of 2002 (I did not have data before this date), the mean price is 1.2891 (median is 1.2824). So, throughout the years, after boom and bust, the mean reversion level for the Euro seems to be the place where it is at now. It does not necessarily say anything about its direction, but it sure does make you realize that the Euro at 1.30 is a comfortable spot for the currency.

The bell curve distribution of the daily closing prices (shown below) adds more validity to the central price.

It is important to know that not all currency pairs exhibit a normal distribution (definition) in  their prices. A quick look at the Pound-US Dollar ($GBPUSD) cross quickly shows how this pair appears to have three different price ranges where it has gravitated towards.

Overall, it is always good to look at the long-term price action of a pair. It tends to give a sense of the currency’s “natural” level, or the place where price is probably neither oversold nor overbought. It also helps you let statements from talking heads on TV along the lines of “this pair does not belong at this or that level” go into one ear and out the other. In a world of clutter and abundant bad information, deciding what to absorb is your best trading strategy.

Now that you’re aware of the Euro’s long term “natural level”, let us turn to the short-term and look at some intraday setups across the board:

VIDEO: FX Alerts: Trendlines, Trendlines, Trendlines

Sources:

Histograms were created using the data below:
Euro and Pound Dollar Daily Data

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Tickers: $EURUSD, GBPUSD

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