Mean Reversion

Mean reversion is the idea that prices, or the relationships between prices, tend to return towards an average after moving to an extreme. A mean reversion trader buys when price is unusually low relative to its average and sells when it is unusually high, expecting a snap back. It is the opposite of momentum: instead of buying strength, mean reversion buys weakness and sells strength. Both effects exist, at different horizons and in different conditions.

Where mean reversion appears#

Measuring "stretched"#

• Distance from a moving average, in percent or in ATRs.
• Z score: how many standard deviations price is from its average. See Percentiles, Quantiles and Z-Scores.

z = (price - moving average) / standard deviation of price

• Bollinger Bands: price at or beyond bands set two standard deviations from the average. See Bollinger Bands.
• Oscillators: RSI below 30 or above 70 on short lookbacks. See RSI (Relative Strength Index).

Strengths#

• High win rates, which are psychologically easier to trade.
• Works well in ranges and choppy markets, where trend strategies struggle.
• Clear reference points: the average acts as a natural target.
• Diversifies trend and momentum strategies.

Risks#

• Fading a real trend. What looks stretched can keep stretching. Markets can stay irrational longer than a trader can stay solvent, as the saying goes.
• Large occasional losses that wipe out many small wins.
• Regime changes: relationships that reverted in the past can break. See Structural Breaks and Regime Changes.
• Catching falling knives in stocks with real bad news.

Making mean reversion safer#

1. Use a trend filter: buy dips in uptrends, not crashes in downtrends.
2. Use stops or time exits. If price does not revert within a set time, exit. See Time Stops.
3. Size conservatively because losses can be fat tailed. See Fat Tails.
4. Avoid averaging down without limits. See Scaling In and Pyramiding.
5. Test for stationarity when trading statistical spreads. See Stationarity, Differencing and Unit Roots.

Momentum and reversion together#

Research finds reversal at very short horizons (days to a month), momentum over 3 to 12 months and reversal again over 3 to 5 years. Many traders run both: mean reversion for short swings and trend following for longer moves, which tend to perform in different market conditions. See Momentum Trading.

Common mistakes#

• Assuming every big move will reverse.
• No stop or time limit.
• Ignoring costs on short, frequent trades.
• Using too short a history to estimate the average and volatility.

Frequently asked questions#

What is mean reversion in trading?#

The tendency for prices or price relationships to return towards an average after moving to an extreme, and the strategies that trade that tendency.

What is the difference between mean reversion and momentum?#

Momentum bets that strong moves continue; mean reversion bets that extreme moves reverse. They tend to work at different time horizons.

What indicators are used for mean reversion?#

Common tools include z scores, Bollinger Bands, short term RSI and distance from a moving average.

Next, trade reversion between two related assets with Pairs Trading.