Mean Reversion
What Is Mean Reversion?
Mean reversion, or reversion to the mean, is a theory used in finance that suggests that asset price volatility and historical returns eventually will revert to the long-run mean or average level of the entire dataset.
This mean level can appear in several contexts, for example, economic growth, the volatility of a stock, a stock's price-to-earnings ratio (P/E ratio), or the average return of an industry.
The Basics of Mean Reversion
Reversion to the mean involves retracing a condition back to its long-run average state. The concept assumes that a level that wanderers a long way from the long-term standard or trend will again return, reverting to its understood state or secular trend.
This theory has led to numerous investing strategies that involve the purchase or sale of stocks or other securities whose recent performances have differed greatly from their historical averages. However, a change in returns likewise could be an indication that a company no longer has the same prospects it once did, in which case it is doubtful that mean reversion would happen.
Percentage returns and prices are by all accounts not the only measures considered 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 focused on the reversion of just relatively extreme changes, as normal growth or other variances are an expected part of the paradigm.
Utilizing the Mean Reversion Theory
The mean reversion theory is used as part of a statistical analysis of market conditions and can be part of an overall trading strategy. It applies well to the ideas of buying low and selling high, by hoping to identify abnormal activity that will, theoretically, revert to a normal pattern.
Mean reversion has additionally been used in options pricing to describe the observation that an asset's volatility will fluctuate around some long-term average. One of the fundamental assumptions of numerous options pricing models is that an asset's price volatility is mean-reverting.
As the figure below depicts, the observed volatility of a stock can spike above or drop below its mean, yet consistently seems to be bounded around its average level. High-volatility periods are typically followed by low-volatility periods and vice versa. Utilizing mean reversion to identify volatility ranges combined with forecasting techniques, investors can select the best possible trade.
Mean reversion trading in equities tries to capitalize on extreme changes in the pricing of a particular security, expecting that it will revert to its previous state. This theory can be applied to both buying and selling, as it allows a trader to profit on unexpected upswings and to save on abnormal lows.
Those interested in learning more about mean reversion theory and other financial topics might need to consider enrolling in one of the best technical analysis courses currently available.
Limitations of Mean Reversion
The return to a normal pattern isn't guaranteed, as unexpected highs or lows could indicate a shift in the standard. Such events could include, yet are not limited to, new product releases or developments on the positive side, or recalls and lawsuits on the negative side.
An asset could experience a mean reversion even in the most extreme event. Yet, similarly as with most market activity, there are few guarantees about what particular events will or won't mean for the overall appeal of particular securities.
Highlights
- Mean reversion trading tries to capitalize on extreme changes in the price of a particular security, expecting that it will revert to its previous state.
- The mean reversion theory has led to numerous investment strategies, from stock trading techniques to options pricing models.
- Mean reversion, in finance, suggests that different phenomena of interest, for example, asset prices and volatility of returns eventually revert to their long-term average levels.
