Mean reversion is a mathematical concept which holds that over time statistical measurements return to a long-run normal. In investing, mean reversion holds that while a market or an asset may go up and down in the short-term, over time, it returns to its long-term trend.
If traders expect a market to revert to the mean, they can use that expectation to inform their strategy going forward.
What Is Mean Reversion?
When stocks revert to the mean, their returns or other characteristics match what they’ve been over a longer period of time than the recent past. This can mean that a stock that becomes highly volatile may revert back to being less volatile; a stock that becomes quite expensive (meaning its price far outpaces its earnings) can become cheap; and, quite importantly, the other way around. Mean reversion can work in both directions.
The mean reversion concept not only applies to individual shares, but also to whole sectors of the economy or of the stock market, like, say, consumer product companies or pharmaceutical companies or any other chunk of the market that shares enough with each other to be classed together. Alternative assets, such as commodities or foreign currencies can also revert to the mean.
The theory applies to more than just prices, the volatility of a given asset can mean revert, which can matter for trading and pricing more exotic financial products like options and other derivatives.
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Mean Reversion Strategies
With any generality or principle of the market comes the obvious question: Is there a strategy here? Can this be traded? Mean reversion trading is a strategy based on reversion to the mean happening, basically that stocks or some asset will return to its typical, long-run historical behavior.
Actually working out a mean reversion strategy is not as simple as thinking a certain stock is out of whack and waiting for things to get back to normal, it requires the ability to flag patterns to make an educated guess about when mean reversion will happen.
After all, if you just know that a stock is going to revert to the mean, you can still pile up large losses or miss out on big gains if you can’t time the reversion correctly — go too early and you’ll have to eat the stock being the “wrong” price before reversion to the mean happens, go too late and the gains have already evaporated as the change in price or returns has already occurred.
The Risks of Mean Reversion Strategy
Mean reversion strategies depend on statistical and historical regularites staying, well, regular. There are some that are pretty well validated, although with sharp and scary exceptions, like that stocks tend to go up over time and outperform other asset classes. But mean reversion involves certain relationships between stocks and assets staying true over time.
In some cases, mean reversion never occurs. Companies or sectors can have continually growing returns over a long period of time if there’s some kind of structural shift in the economy or market in which they operate. This can mean that returns increase over time or stay quite high.
This can happen for a few reasons. A company could gain or lose a dominant position in a given market, technological changes can advantage certain firms and disadvantage others, such that returns move permanently (or at least close enough to permanently for a given investment strategy) to a higher level and lower to another. Or there could be a global pandemic that permanently changes the way that companies do business, or long-run inflation that impacts profitability.
How to Implement a Mean Reversion Strategy
There are some basic statistical and financial tools to help create mean reversion strategy. As always, active trading and trying to time the market is risky and sometimes the whole market moves up and down and that can swamp whatever strategy you might have for an individual stock or sector.
Part of implementing a mean reversion strategy is getting a sense of stock trends or a trend trading strategy, whether past movement in a stock up or down is indicative of continuing in that direction.
This can involve trying to discern bullish indicators for stocks, giving you a sense of when stock returns are likely to go up. Often traders combine this strategy with forms of technical analysis, including the use of candlestick patterns.
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Alternatively, you will need to have a sense of when a stock is underperforming in order to profit from buying it before it reverts to the mean upwards.
Factors in Creating a Mean Reversion Strategy
There are many factors that institutional and retail investors need to consider when devising a mean reversion strategy.
Determining the Mean
In this case, you’ll need to think about what period of time you are using to determine a stock or sector’s “normal” or “average” behavior. This matters because it will determine how long you decide to hold a stock or when you plan to sell it before or after the reversion to the mean occurs.
To execute a mean reversion strategy, you have to know when a stock’s price movement is sufficient to execute the trade. It helps to determine this point in advance.
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Determine the Bounds
What is the “normal” behavior, whether it’s price-to-equity ratio, volatility, or some other metric you’re looking at. To determine whether something is far beyond its mean, either high or low, you need a good sense of its normal range.
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Mean reversion and trading reversion to the mean is, of course, a quantitative endeavor. You need to compile statistics and make projections going forward in order to implement the strategy. But you also need to know what’s going on in the “real world” beyond the statistics.
If something is driving prices or volatility or some other metric higher or lower that’s likely to persist over time, mean reversion may not be a great bet. If, however, there’s something truly transient that’s the catalyst for large moves up and down that will then revert to the mean, then maybe the strategy is more likely to work.
As with most investments, it’s helpful to have an exit strategy determined ahead of time. This can help you limit your losses in the case that the asset ultimately does not revert to the mean.
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Mean reversion refers to an asset’s tendency to stick to typical value increases over time. Again, while volatility may play a role in short-term price or value changes, most assets will follow a long-term appreciation line, and despite short-term rises or falls in price, they’ll likely revert to the mean.
Traders who follow mean reversion strategies assume that a specific stock or sector will return to its long-term characteristics. The strategy can be helpful when determining an investing strategy for either individual assets or for a market, overall.
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