Mean Reversion: Definition & How to Use it Best in Your Trading?

Trading concepts

Mean reversion

What Is Mean Reversion?

Mean reversion, or reversion to the mean, is a term used in finance. It indicates that asset price volatility and historical returns eventually will go back to the long-run mean or average mark of the whole dataset.

What is mean reversion in trading?

Mean reversion in trading indicates that prices appear to return to average levels. And it also predicts extreme price moves are difficult to hold for elongated periods. Traders who get involve in mean reversion trading have created several means for capitalizing on the theory. In every cases, they are betting that an extreme level (either it be volatility, price, growth, or a technical indicator) will return to the average.

The Basics of Mean Reversion

Reversion to the mean involves retracing a case back to its long-run average condition. The concept presumes that a level that strays far from the long-term norm or trend will again come back. It’ll revert to its understood condition or secular trend.

This theory has resulted into several investing techniques. They involve the buying or selling of stocks or other securities whose recent performances have taken largely different turns from their historical averages. However, a change in returns also could be an indication that a company no longer has the same opportunity it did initially. In which case it is less certain that mean reversion would take place.

Percentage returns and prices are not the only measures taken into consideration in mean reverting; interest rates or even the P/E ratio of a company can be subject to this phenomenon. The theory of mean reversion is subjected to the reversion of only relatively extreme changes, as normal increase or other fluctuations are anticipated part of the paradigm.

Mean reversion has equally been used in options pricing to explain the observation that an asset’s volatility will fluctuate around some long-term average. One of the basic assumptions of several options pricing models is that an asset’s price volatility is mean-reverting.

Mean reversion trading in equities attempts to leverage on extreme changes in the pricing of a specific security. It assumes that it will go back to its initial state. This theory is applicable to both buying and selling. It enables a trader to profit on unanticipated upswings and to save on abnormal lows.

Mean reversion formula

To have a grasp and to calculate mean reversion, traders need to calculate the mean. The mean is the average price over a given number of data points.

On an asset’s trading chart, the mean is simply denoted by a simple moving average (SMA). The SMA calculates the average price in the price series. With time, prices tend to move around the average or SMA, at the end returning to it.

Trades can make use of different metrics, such as distance from the SMA. It helps to indicate when the price could return to the mean. A few technical indicators have their own formula and tries to alert traders when the price is close to extreme marks and may revert:

  • Bollinger Bands
  • Regression channels
  • Keltner channels
  • Envelopes

However, as it always the case in trading, these can only give signals and are not a guaranteed indication of reversal.

Example of mean reversion

While an instrument’s price appears to revert to the average with time, this does not always shows that the price will fall back to the mean, or that the price will rise to mean. The mean is also moving, so if the price lingers and moves only a little, the mean price has the opportunity to catch up. That also counts as mean reversion.

Other indicators such as Bollinger Bands​​ makes use of standard deviation to determine how far away the price is from the mean. The wider apart standard deviations are from the mean, the more likely the price is to revert to the mean. Although that may not occur immediately.

Mean reversion strategies

Mean reversion strategies tries to capture profits as the price of an asset reverts to more normal levels, or the average. When thinking about making use of a mean reversion strategy in your trading, note that a price rising away from the mean doesn’t particularly denote that the price will drop. The mean could also basically rise up to meet the price. That would also add reversion to the mean since the price has returned in line with its average. While reversion to the mean takes place often, prices barely remain exactly at the mean for long.

Some common examples of mean reversion strategies

Mean reversion in pairs trading: pairs trading​involves searching for two closely correlated assets. The prices of these assets tend to go together. When the prices moves away from one another; for example, one drops when the other fails to, this creates a likely mean reversion trade. This can sometimes also be referred to as statistical arbitrage.

Intraday mean reversion trading strategy

Intraday strategies deals with the buying and selling of multiple assets in the entirety of a single day and positions are usually not held overnight. With day trading, some traders choose to take trades around a moving average.

If there exist an uptrend, the price appears to move up from the average and then drops back to it. When the price returns to the average, this may open up a buying window. If a downtrend exists, then the price tends to drop beneath the average and then move back to it. When the price is close to the average, this may give a chance to take a short position (sell) instead.

Mean reversion forex strategy

Here is a strategy that traders may take into consideration for forex trading. It is observing how far the price tends to move away from the mean before going back to the mean. This can be performed on a trading platform by using a moving average convergence divergence (MACD) or Percentage Price Oscillator (PPO).

Using the Mean Reversion Theory

The mean reversion theory is adopted as part of a statistical analysis of market conditions. This can be included in the overall trading strategy. It fits perfectly to the ideas of purchasing low and selling high. It anticipate to detect abnormal activity that will theoretically, return to a normal pattern.

Limitations of Mean Reversion

The return to a normal pattern is not assured. Unforeseen highs or lows could signify a move in the norm. Such situation could include, but are not restricted to, new product launching or developments on the positive part, or recalls and lawsuits on the negative part.

An asset could go through a mean reversion even in the most extreme situation. But just like the case of most market activity, there are minute assurance about how specific events either will or will not affect the overall appeal of particular securities.

Conclusion

Mean reversion in finance, suggests that different phenomena of interest such as asset prices and volatility of returns in the end go back to their long-term average levels.

The mean reversion theory has resulted into many investment strategies, from stock trading techniques to options pricing models.

Mean reversion trading attempts to focus on extreme changes in the price of a particular security, should in case it will returns to its initial state.

Due of these uncertainty, most professional traders have strict risk-management​​ protocols. They can define an exit point where their position will close out if the price fails to go in their anticipated direction, helping to reduce losses as much as possible.

Russell Crane

Russell Crane

Russell is an Algorithmic & Technical Analyst Trader @ PatternsWizard.
His passion is to share his knowledge about TA, patterns & more. Why hope for your trading to work when you can precisely know the performance stat of every pattern?

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