Mean Reversion

What Is Mean Reversion?

Mean Reversion is a trading strategy based on the idea that prices and returns eventually move back towards the mean or average level over time. The assumption is that extreme price movements in either direction are temporary, and the price will revert to its long-term average.

Key Features

Average Price Level: The strategy relies on the concept of an "average" price, often determined by historical data or technical indicators like the moving average.
Overbought and Oversold Conditions: The strategy looks for situations where an asset has deviated too far from its average price, indicating it may be overbought (too expensive) or oversold (too cheap).
Reversion to the Mean: Traders expect the price to revert back to the average level, so they trade in the opposite direction of the price movement.

How It Works

Traders using mean reversion will identify an asset’s average price over a certain period (like the 50-day moving average) and look for instances where the price has deviated too far from this average. If the price moves too high, they may short the asset, expecting it to fall back to the mean. If the price drops too low, they may buy, expecting it to rise back to the average.

Example

Suppose a stock typically trades around $100, but for the past week, it has risen to $120. A mean reversion trader might believe that the price is "too high" and expect it to fall back to the average of $100, so they might enter a short position. Conversely, if the stock dropped to $80, they might buy, betting that it will rise back to $100.

Benefits

Profit from Price Correction: Traders can profit when prices move back to their historical average after deviating too far.
Simplified Strategy: Mean reversion strategies often rely on clear technical indicators, making them relatively easy to follow.
Useful in Sideways Markets: This strategy works best in markets that don’t show strong trends but instead move within a range.

Risks

Trend Reversals: If the asset’s price is breaking out of its historical range (due to fundamental factors), it might not revert to the mean, leading to significant losses.
Market Noise: Small price fluctuations that are temporary might signal false opportunities, causing traders to enter trades that don’t work out.
Not Suitable for Trending Markets: In trending markets, prices may continue to move away from the mean, and mean reversion strategies may fail.

In Short

Mean Reversion relies on the idea that asset prices will eventually return to their long-term average. Traders use this strategy to capitalize on extreme price movements by betting that the price will revert to its "normal" level. However, it’s important to be cautious of strong trends or fundamental changes that could disrupt this pattern.