What is Mean Reversion?
Mean reversion is a theory used in finance that suggests that asset prices and historical returns eventually return back to the long-run mean or average level of the entire data set. This mean or average can be the historical average of the price or return, or another relevant average such as the growth in the economy or the average return of an industry.
- Mean reversion refers to the phenomenon that prices or returns will fluctuate around a long-term average level.
- The thought is that any price that strays far from the long-term norm will again return, reverting to its understood state.
- This theory has led to many investing strategies from stock trading to options pricing.
The Basics of Mean Reversion
This theory has led to many investing strategies involving the purchase or sale of stocks or other securities whose recent performances have greatly differed from their historical averages. However, a change in returns could be a sign that the company no longer has the same prospects it once did, in which case it is less likely that mean reversion will occur.
A reversion to the mean involves the retracement of any condition back to a previous state. In cases of mean reversion, the thought is that any price that strays far from the long-term norm will again return, reverting to its understood state. The theory is focused on the reversion of only relatively extreme changes, as normal growth or other fluctuations are an expected part of the paradigm.
Mean reversion has also been used in options pricing theory to describe the observation that an asset's volatility will fluctuate around some long-term average.
Using 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.
The return to a normal pattern is not guaranteed, as an unexpected high or low could be an indication of a shift in the norm. Such events could include, but are not limited to, new product releases or developments on the positive side, or recalls and lawsuits on the negative side.
Even with extreme events, it is possible a security will experience a mean reversion. As with most market activity, there are few guarantees on how particular events will or will not affect the overall appeal of particular securities.
Mean reversion trading looks to capitalize on extreme changes within the pricing of a particular security, based on the assumption 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 save at the occurrence of an abnormal low.