Mean reversion is a financial theory stipulating that asset prices and historical returns tend to move towards their long-term average levels. The average level can be in the context of the overall economic growth or the return of the underlying industry, or any particular data set. This means that over time, prices will oscillate around the average prices, and the bigger the diversion from the mean, the stronger the likelihood that prices will revert to it.

Every trading strategy is based on either exploiting mean reversion or momentum in the market. Financial markets spend more time in consolidation mode compared to trending phases. Incorporating a mean reversion strategy in your trading activity is very important and potentially lucrative.

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Mean Reversion in Trading

Mean reversion is, in essence, a market timing strategy. In particular, mean reversion traders target extreme price variations that they expect to revert to normal. Mean reversion bodes well with the philosophy of buying low and selling high. The volatility of an underlying asset determines how far above or below the price it will spike from its mean. The important thing for a mean reversion trader is that an asset’s price remains bounded by its mean and will always revert when extreme spikes happen.

Reversion to the mean can also help in accurately pricing options. Options are derivative contracts that give investors the right to buy or sell an underlying asset at a predetermined price on or before a set date. Depending on how far the selected execution price is from historical average prices, options can determine whether a call or put contract is the high probability trading decision. For instance, if the strike price is far below historical averages, a call option that bets on higher prices at expiry may be the more logical and wise trading option.

Mean Reversion Trading Strategies

When it comes to a mean reversion trading strategy, it can be applied in all market conditions and different asset classes. It is important to note that when the price moves away from its mean, say it is rising, it is not necessary to fall because the mean can also rise to meet the price.

This principle is vital to trade directional markets. In a strong uptrend, for instance, mean reversion will dictate that buy entries be made when the price has made a correction (reverting to its mean).

The mean reversion indicator can also help make contrarian trades in directional markets. For instance, a stock’s price has been rising by an average of 10% in previous months due to strong industry fundamentals. If the price of that stock makes a 30% increase in a particular month without any new positive fundamentals, investors may view this as an opportunity to short a ‘good’ stock in the market for the short term. In a ranging market, the strategy will be to buy when the price falls to a certain extent below the mean and sell when it has risen considerably above its mean.

Mean reversion is also applicable in pairs trading. This refers to assets that have a particular relationship in a portfolio. For instance, consider two closely related stocks such as Pepsi and Coca-Cola. The stocks are expected to move similarly because they face similar business prospects and conditions. If, for instance, Pepsi stock rises by 30%, but Coca-Cola only posts a 10% increase, investors may exploit this short-term ‘anomaly’ by buying the ‘cheaper’ Coca-Cola stock and shorting the ‘expensive’ Pepsi stock. This strategy can also be applied in assets such as currency pairs, where the strategy will be to buy strong currencies while selling weak ones simultaneously.

Successful mean reversion strategies involve the effective timing of entry and exit prices. There are technical indicators that can help in this regard. Trend following indicators, such as moving averages, are utilized by traders to gain a perspective of ‘mean’ prices. There are also oscillators, such as the RSI, which will help investors identify overbought and oversold conditions in the market. These are essentially levels where there is an extreme deviation from average prices.

Another set of complementary indicators for mean reversion is trading bands, such as Keltner Channels and Bollinger Bands. These indicators are practical because they seek to ‘contain’ the price within defined bands. Significant price deviations from the bands could present lucrative opportunities for the price to fade from the prevailing trend to revert within the bands.

Limitations of the Mean Reversion Theory

While mean reversion is a logical market hypothesis, it also has limitations. First, a return to normal or mean prices is not guaranteed. A significant price change in the market may reflect a new normal on the underlying asset. For instance, a stock may fall because of a significant change in the regulatory environment. This permanent factor will provide a significant headwind on the stock in the long run.

Mean reverting strategies also limit the profit potential of single trades. Whereas markets consolidate more than they trend, it is trending phases that generate significant price changes where big profits can be realized. Mean reversion traders will always look for contrarian opportunities in such markets and thereby miss out on enormous potential profits by simply following the overall trend.

Finally, mean reversion can take long to become a self-fulfilling phenomenon in the markets. A common adage in investing is that markets can remain irrational longer than you can remain solvent. Thus, mean reversion strategies may not work out as envisioned for traders with short time horizons in the markets.

Final Word

Mean reversion is an integral theory to understand for all types of investors. But while prices tend to revert to their mean, now one knows when they will exactly do so. This means timing the best entries and exits using mean reversion can be risky. Therefore, it is crucial to understand the limitations of mean reversion and use its strategies in appropriate market conditions to reduce the risks involved.

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FAQ

  • What is Mean Reversion?

    Mean reversion is a financial theory that suggests that prices of financial assets will tend to revert to their historical averages over time.

  • Is Mean Reversion a Good Strategy?

    Yes, it is. But it is important to apply it in appropriate market conditions to limit risks.

** Disclaimer –While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.