Investing > Complete Guide to Mean Reversion

Complete Guide to Mean Reversion

Mean reversion gives investors the means (pun intended) to decipher and take advantage of large price changes.

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Updated January 12, 2023

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Do you wish you could know how to react to important changes in the market?

Of course, some principles of investing are ubiquitous – everyone wants to pay as little as possible for an asset and sell it for as much as possible. But financial markets are incredibly complex and dynamic. Sure, a stock that has seen a big decrease in price might now be affordable – but what if it continues dropping? 📉

Gut-feeling and hunches don’t count for much when it comes to investing. In order to succeed, an investor needs a reliable method to analyze what’s going on, interpret the given circumstances, and formulate a response. Mean reversion is one of two such methods.

But it isn’t simple, and it will require time and effort to master. The topic before you is complex and dense. Fair warning – there will be a lot of mathematics and statistics involved – don’t say that we didn’t warn you. ⚠

Now that we’ve gotten that disclaimer out of the way, it actually isn’t all that scary or incomprehensible, although it might seem like it. Most people aren’t familiar with the metrics and terms that are of chief importance when it comes to mean reversion, so it’s all the more important to present it in a clear, easily understandable way.

As we’ve said, this is one of only two approaches to the issue of long-term changes in the stock market. And it isn’t a case of picking your preferred option – a competent investor has to know the ins and outs of both of these approaches.

The bottom line is, there’s no going around or avoiding this stuff. And there’s no time like the present – so let’s embark on the important work of mastering today’s topic.

What you’ll learn
  • What is Mean Reversion?
  • How Mean Reversion Works
  • Applying Mean Reversion Theory
  • Examples of Mean Reversion
  • Directional vs. Relationship Mean Reversion
  • Mean Reversion Trading Strategies
  • Pros and Cons of Mean Reversion
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is Mean Reversion? 📘

Mean reversion is a theory in finance that states that eventually, various important metrics always return to the long-term average or mean – no matter how significant, sudden, or important a change may seem.

Mean reversion offers investors a method that can be applied to various data points on a chart in order to acquire actionable information that can be used to formulate various investment strategies. This statistical approach can be used to analyze average returns, price-to-earnings ratios, volatility, and even the economic growth of entire sectors, technical indicator levels, earnings, and earnings growth rates.

Understanding How Mean Reversion Works

So, how exactly does mean reversion work? As we’ve established, the theory holds that any deviations in these important metrics will face a correction to the mean sooner or later. Mean reversion works by identifying these deviations, and using the upcoming correction in order to profit.

Let’s use the example of a stock that has seen unexpected growth in share price. If we’re using the logic of mean reversion, the stock’s price will eventually slide back to the previous mean. If we can use data to establish that such an unexpected change in price has indeed occurred, we can then short the stock and profit from the upcoming price correction.

Conversely, if a stock has seen a large drop in price, the tenets of mean reversion posit that this is a strong signal to buy the stock at a discount.

Regression Explained 👨‍🏫

A regression line is a tool used to plot the price around which an asset’s price oscillates in a certain timeframe. This is a very useful drawing tool – in essence, it serves to provide traders with a clear and easy-to-understand picture of what normal price levels look like.

Most of the top online brokers for beginners include this drawing tool, which is considered essential for technical analysis. We’re going to use an example to show how it works, and how to interpret the basic elements of regression.

Visual chart of  linear regression displaying 3 lines that highlight the biggest price increases within a given timeframe
Regression lines are used to show or predict the relationship between two variables or factors – price points in this instance. Investors aren’t required to draw these manually as most online brokers provide this tool.

As you can see in the image above, this drawing tool shows three lines. The middle line is the regression line – this marks the price that the asset usually reverts to. The topmost and bottommost lines show the biggest increases or decreases in price that occurred during the selected timeframe.

This example is a good way to visualize the entire topic of mean reversion – as you can see, price changes do occur, but sooner or later, the price of the security in question reverts to an average or mean.

Applying Mean Reversion Theory 👨‍💻

The basic hypothesis of mean reversion is clear enough – volatility is temporary, and prices eventually return to the mean. So, how can a trader apply this in practice?

If all big price changes are bound to be reversed, you’re in a position to know what is going to eventually occur. In essence, every single big change in price is an opportunity – whether the price has gone up or down, you can use the eventual market correction in order to profit, either by buying or selling a stock, or shorting it.

For example, during the pandemic Netflix experienced a spike in its share price as demand for the streaming service grew. But, with the pandemic easing and the rise of competing streaming services, $NFLX has since lost its gains and returned to the price it was going for in March 2020. An investor with knowledge of mean reversion and how it works could have anticipated this price dive during the pandemic, as they would have known that the spike wouldn’t last forever.

Keep in mind, however, that the market doesn’t exist in a vacuum. Yes, mean reversion is highly technical and relies on data, but that data has to be placed in context to be properly understood. For starters, let’s focus on identifying the mean, and then we’ll move on to concrete strategies that can be put into play.

The Formula 🧮

When most people hear “formula”, the alarms go off – but don’t worry, you won’t have to do any complex math or complicated equations – all of that is automated nowadays. To calculate the mean for an asset, just use a simple moving average (SMA).

This tool will automatically calculate the average price in a price series. To put it into slightly more understandable terms, the SMA takes the security’s closing price for each day during a certain timeframe (20 days, 200 days, 50 weeks), and averages them.

But calculating the mean isn’t enough – that information alone doesn’t let you know when the reversion is going to occur, and whether or not it is the optimal time to enter a position. We’ll focus on that in a later section – for now, just try to get acquainted with the method of calculating the mean.

Visual chart of a moving average indicating the ups and downs of $NFLX in 2021
The moving average (orange line) is a good indicator of support during uptrends, and resistance during downtrends. Image by TradingView.

But calculating the mean isn’t enough – that information alone doesn’t let you know when the reversion is going to occur, and whether or not it is the optimal time to enter a position. We’ll focus on that in a later section – for now, just try to get acquainted with the method of calculating the mean.

Examples of Mean Reversion 📝

One of the key assumptions of mean reversion is that prices tend to revert to the mean eventually. However, this does not imply that price is always the factor that will change – the mean, a mathematical function similar to an average, is also subject to change.

Graphic representation of mean reversion on a candlestick chart
On an asset’s trading chart, the mean is represented by a simple moving average. Traders can use various metrics, e.g. distance from the SMA, to establish when the price could revert back to the mean.

As you can see on the chart above, prices do in fact tend to move near the mean – however, breakouts and new trends do occur at times. This doesn’t mean that mean reversion doesn’t hold true – the new price movements eventually form a new mean or average, seen above, which catches up, and a new period of relative stability ensues.

Directional vs. Relationship in Mean Reversion Compared ⚔

Mean reversion is a wide term, and it encompasses a variety of strategies. However, a vast majority of these can be grouped into one of two categories – directional mean reversion, and relationship mean reversion.

Directional Mean Reversion 🎯

Directional mean reversion focuses on a single security. This approach seeks to identify the direction of an upcoming price movement and is favored by retail traders. A vast majority of mean reversion strategies fall into this category, and so too do most of the strategies that we’ll be covering in this guide.

In essence, directional mean reversion strategies boil down to purchasing a security when its price moves too low in comparison to the mean and selling it when the price has increased too much when compared to the mean.

Relationship Mean Reversion 🔗

Relationship mean reversion is an approach that seeks to profit off of the relationship between two securities. In slightly more technical terms, this approach consists of finding a pair of highly-correlated securities, identifying a discrepancy in price movements, and then profiting off of the eventual reversion.

We’ll go into more depth down below when we cover pairs trading, so let’s boil this approach down to the basics. We have two stocks, and we’re going to use the quintessential example of relationship mean reversion – Coke and Pepsi. They are highly correlated – they experience the same increases and decreases in price, which are caused by the ebbs and flows of the soft drinks and consumer staples markets.

When this correlation is disrupted – say, Coca-Cola’s stock price rises by 15% and Pepsi is still trading at the price that it used to, mean reversion posits that eventually, either Pepsi stock will rise to meet Coke or Coke will fall to meet Pepsi. In this case, a trader would buy stock in Pepsi and sell or short stock in Coca-Cola.

Mean Reversion Trading Strategies 🗃

Alright – we’ve gone through all of the theory, explained how mean reversion works, and what forms it can take. So, how can a trader put this information into practice?

Quite a few trading strategies depend on mean reversion. In essence, they all try to accomplish the same thing – profit from asset prices that are returning from abnormally high or low levels back to an average price.

Intraday Strategy ☀

Intraday trading is the buying and selling of a security multiple times within the confines of a single trading day. These positions aren’t held overnight, and the goal is to make many small yet profitable trades.

With this strategy, the basic tool that traders use is a moving average. For example, if an uptrend occurs, the price is going to move from the average before reverting to it. In this specific case, the moment when the price reverts to the average is a good buying opportunity.

Likewise, the reverse holds true. If there is a downtrend, prices tend to fall before reverting to an average – when they do revert to an average, this tends to be a good opportunity to short or sell.

While this might all sound quite simple in theory, executing this strategy isn’t quite so straightforward. First of all, traders must identify a strong trend – without a strong trend, this strategy is much less reliable. Second of all, on top of that, the moving average should exhibit a certain type of behavior – with prices getting near the moving average and then moving in the direction of the abovementioned trend.

Pairs Trading Strategy 👥

Trading pairs is an approach that relies on finding two assets that exhibit high correlation – in other words, two assets whose prices tend to move in the same direction. This is an example of relationship mean reversion. So, how do you use mean reversion to trade two correlated assets?

It’s rather simple, actually. When the prices of the two assets deviate, that is to say, move in opposite directions, there is an opportunity to make a trade. This occurrence is also called statistical arbitrage.

Let’s use an example. This occurrence is quite common with stocks in the same industry, and that’s also the case with famed pizza makers Papa John’s and Domino’s. Both of these companies have experienced similar highs and lows, depending on the state of the overall pizza market.

In this case, if Domino’s stock were to suddenly rise, while Papa John’s stayed the same, a trader would sell or short Domino’s, while buying Papa John’s. The logic is simple once viewed through the lens of mean reversion. If the prices indeed revert to a mean, Papa John’s stock price will rise, meaning that buying it was profitable, while Domino’s stock price will fall, meaning that shorting or selling it was likewise profitable.

In this case, if Domino’s stock were to suddenly rise, while Papa John’s stayed the same, a trader would sell or short Domino’s, while buying Papa John’s. The logic is simple once viewed through the lens of mean reversion. If the prices indeed revert to a mean, Papa John’s stock price will rise, meaning that buying it was profitable, while Domino’s stock price will fall, meaning that shorting or selling it was likewise profitable.

Forex Trading Strategy 💱

Forex trading is quite a different ball game when compared to trading other securities such as stocks – however, the principles behind mean reversion apply to foreign currency trading just the same.

When applying mean reversion to forex trading, the goal is to determine how much, on average, prices oscillate from the mean before reverting to it. Once that is achieved, traders have a clear framework with which to determine when to buy and sell.

Most forex traders prefer candlestick charts, which you should definitely get acquainted with – but even if it is unfamiliar to you, don’t worry. This strategy uses an indicator that takes a lot of the legwork out of the entire process – the moving average convergence divergence or MACD.

The MACD functions by comparing the closing price of a certain period to the average price of a specified timeframe. When using MACD, trendlines clearly show at what price points deviations from the mean occur, and when the inevitable reversal happens. As an added bonus, most forex brokers have this drawing tool already built in.

EUR/USD forex pair seen in the upper portion, with MACD indicator plotted on the bottom half.
An MACD setting is usually expressed in three numbers; the default with most forex brokers is 12, 26, 9.  Image by TradingView.

There are a couple of obvious plays to be made here – when prices oscillate above the mean, a selling opportunity is at hand, and the reverse holds true when prices oscillate below the mean. 

However, forex trading is dynamic, fast-paced, and unpredictable – we strongly caution you to use complex order types such as stop-loss orders to alleviate the risk you’re putting yourself at if the trend should continue.

Trading Bands 📊

Trading bands or Bollinger bands as they are more commonly referred to are one of the most popular trading indicators – and for good reason. Bollinger bands are used to determine whether or not an asset’s current price is relatively high or low.

The chief advantage of Bollinger bands is that they are quite flexible – as far as time frames go, they can be used to determine price action through an hourly, daily, weekly, and even monthly lens.

Okay, first things first – Bollinger bands are never used on their own. The first step to applying them is to plot a standard moving average. Once that is done, you can plot in the Bollinger bands, which are plotted at a standard deviation level, which is a measure of volatility.

Because the bands are a representation of volatility, they widen when volatility rises, and contract when it decreases. On top of that, periods of extremely low or high volatility tend to follow one another – which can serve as a handy hint for when to enter a new trade, provided that you corroborate that information by using other metrics.

Graphic representation of breakouts followed by price corrections in an S&P 500 chart.
In most cases, a breakout is a sign that a price correction is about to happen. Image by TradingView.

The second key concept with Bollinger bands is breaking out – which is what happens when the price of a security moves past either the upper or the lower band. This indicates that an asset is either overbought or oversold, respectively, and is considered a strong sign of an upcoming correction.

Linear Regression ⌚

Linear regression is a directional mean reversion strategy that is among the easier ones to execute. The strategy functions by plotting a linear regression line – which is basically a sideways line that shows us the price action which took place during a specific time period.

The idea behind plotting a linear regression line is to determine the range in which a security has been trading over a specified time. Once that range has been established, you know what the mean is. But that’s only the beginning – now we need to deal with the price fluctuations that have occurred in that timeframe, in order to determine the best entry points for trades.

The next step is to plot standard deviations from the initial linear regression line. Once you determine the upper and lower range of the deviations, you can plot two additional lines that will function more or less like support and resistance lines.

Now that all of that is in place, all the preparations are finished. The most straightforward approach is to sell or short securities when they’re near the upper or “resistance” line, as this signals that the security is overbought and that a correction is coming soon. In much the same way, if a security is near the lower or “support” line, you might be looking at a good opportunity to buy.

Technical Indicators 📃

Finally, we come to the topic of technical indicators. Mean reversion is a catch-all term for a wide variety of strategies, but all of them have one thing in common – most of them require the use of an additional technical indicator to be properly executed.

There are too many to list here, but the meat of the matter is that finding an approach that works for you isn’t always straightforward. As your experience in technical analysis and trading continue to grow, you’ll become aware of more and more indicators – and eventually, by utilizing them in tandem with mean reversion, you might develop a strategy of your own.

We’ve covered the most frequent and important approaches, but we should also include a list of honorable mentions. If you’re interested in more, take a look at indicators such as Keitner channels, relative strength index (RSI), stochastics through the lens of mean reversion – these approaches might be a bit more niche, but they deserve consideration nonetheless.

Pros and Cons of Mean Reversion ⚖

We’ve covered everything there is to know about mean reversion. Still, in order to fully understand a thing, one has to consider its faults, potential shortfalls, and take a look at opposing viewpoints. And just like almost everything in finance is a point of contention, so too is mean reversion – it isn’t without its detractors.

For starters, supporters of the efficient market hypothesis find the entire premise of mean reversion unsustainable. According to this hypothesis, the market reflects all available information at all times – prices are always rational, so a sudden increase or decrease has to be due to some specific reason. If that is indeed the case, there is no guarantee that a price correction to the previous mean is going to occur.

And to be clear, there is no guarantee that a stock’s price always returns to the mean. Sure, it is a common occurrence, but things like new products, increased earnings, or good press can easily lead to a new paradigm – a new, long-term increase in the stock’s price.

On the other hand, the strategy of mean reversion does have a lot of pros and advantages. For one, it has a rather simple and easy to execute exit strategy – buying or selling when prices return to the mean is simple. It isn’t exactly a risky play, so the win rate of this strategy is decent, and the risk-adjusted returns are nothing to scoff at.

Conclusion 🏁

That’s it as far as this guide is concerned – and thanks for sticking by us till the end. Statistics and abstract terms in finance aren’t the most appealing reading, but having a solid grasp of this topic will prove beneficial in the long run.

In the financial markets, the changes in an asset’s price are the main driving point of any approach or strategy. Identifying large changes, as well as whether or not they will continue to hold and become a trend, or whether and when they will reverse can give an investor a huge leg-up on the competition.

Mean Reversion: FAQs

  • What Does the Mean Reversion Indicator Mean?

    Mean reversion indicators allow us to measure how far, on average, a price can swing in any direction away from the mean before a price correction back to the mean occurs.

  • Do Mean Reversion Strategies Work?

    Yes, mean reversion strategies tend to have a rather high success rate, although that depends chiefly on whether or not an investor can competently and properly execute these strategies, as they are not particularly easy or simple to implement.

  • What is the Opposite of Mean Reversion?

    The opposite of a mean reversion would be a sustained breakout trend, which forms the basis for an entirely different approach - the strategies of momentum trading.

  • Is Volatility Mean-Reverting?

    Yes, volatility is mean-reverting, and this fact applies both to realized and implied volatility.

  • Is Mean Reversion a Good Strategy?

    Provided that you have the time and willpower to properly master mean reversion, it is a very good strategy. Keep in mind, however, that it isn’t the most simple approach, and tends to work better for stocks than in the case of other asset classes.

  • Which Moving Average is Best for Mean Reversion?

    The best moving average to use will depend on your particular strategy - with shorter moving averages being a better fit for short-term strategies and longer averages for longer strategies. Keep in mind, however, that you should always use a mean reversion indicator in conjunction with moving averages.

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