Mean Reversion.
What is the 'Mean Reversion'
Mean reversion is the theory suggesting that prices and returns eventually move back toward the mean or average. 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.
BREAKING DOWN 'Mean Reversion'
Percent returns and prices are not the only measures considered mean reverting; interest rates or even the price-earnings ratio of a company can be subject to this phenomenon.
A reversion involves the return 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.
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 back 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.
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.

An Introduction To Mean Reversion Trading And The 4 Biggest Challenges.
Contents in this article.
Mean reversion trading is often referred to as counter-trend or reversal trading which all, more or less, describe the same type of trading style. A mean reversion trader looks for price that has moved away significantly from its mean (average) price; the mean reversion trader looks for unsustainable trends.
Although most people prefer the trend-following approach, I never felt comfortable with the general trend-trading mindset and I started looking at mean reversion trading very early on. Needless to say, I got burned a few times in the beginning since this trading style is not suited for absolute beginners due to the emotional and psychological challenges it poses on the trader. In the following article, we take a look at mean reversion trading, what the most overlooked aspects are and which challenges a mean reversion trader has to deal with.
Mean reversion trading – a brief introduction.
As said above, a mean reversion trader is looking for opportunities where price has moved away from its mean (or average) price significantly. Usually, the mean price is calculated by using a moving average and applying it to the charts. For example, the chart below shows the EUR/USD Daily chart and a 50 period smoothed moving average.
As you can see, price frequently pulls away from the blue moving average and then snaps right back to it. If this sounds too good to be true, it is. Of course, those hindsight-charts with the perfect trades only tell half of the story.
click to enlarge.
The screenshot below shows the same EUR/USD Daily timeframe with the same moving average. But this time, I marked all the pullbacks that did not make it all the way to the moving average. And, of course, if we’d look closer, there would be many more times when price attempted a reversion, but it failed. Therefore, mean reversion trading is more than just trading back to the moving average and it requires a very strict entry management, risk management approach and an emotionally stable character to avoid things such as revenge-trading or over-trading.
click to enlarge.
The 4 main challenges of mean reversion trading.
In the following, we take a look at the most commonly overlooked aspects that make mean reversion trading harder than it seems at first glance.
#1 How do you determine the mean?
Although this seems very obvious, most traders never think about the implications their choice of the moving average has on their trading. Let’s take another look at the EUR/USD chart from above. This time we applied two different moving averages: the 100 smoothed moving average (SMA) in red and the 50 SMA in blue. The differences may seem insignificant, but for a mean reversion trader, choosing the correct moving average is one of the most important decisions and it also is a very personal and individual one. These are the main differences between the two types of moving averages:
As you can see, this is not judgmental and there is no right or wrong when it comes to choosing a moving average for your trading. Instead, I want to highlight the fact that the choice of the moving average has wide-ranging consequences on your trading style and it has to be made based on personal preferences and character styles.
click to enlarge.
#2 Sometimes price does not reverse, but the moving average catches up with price.
The second most overlooked and undervalued aspect is that sometimes the reversal happens very slowly and in the meantime, the moving average moves closer towards price and, thus, reduces the reward:ratio of the trade.
The screenshot below illustrates the point. Although, at first glance, it looks like the mean reversion strategy works like a charm and price always comes back to the moving average, it is important to understand that sometimes, the moving average catches up with price faster and can reduce the initial reward:risk ratio and consequently the expectancy of such a trading strategy. A trader then has to decide if he leaves his initial take profit order unchanged or if he moves his take profit along with the moving average.
click to enlarge.
#3 Mean reversion vs. catching a falling knife.
Picking tops and bottoms can be a very dangerous thing to do in trading and amateur traders, especially, often engage in such trading behavior because they underestimate the fact that price can keep on trending much longer than they think. During periods of long-lasting and strong trends, trading mean reversion can often lead to significant losing streaks without taking precautions. The screenshot below shows the current EUR/USD Daily chart and it took price about 300 trading days to eventually meet up again with the moving average.
click to enlarge.
A mean reversion trader is not waiting with pending orders at predetermined levels, as standing in front of an approaching train, but rather waiting until the train has come to a stillstand and offers clues that it’s going the other way.
#4 Emotional stability and discipline.
Although this is true for all types of trading, it is especially important for mean reversion traders. It can take very long until a trading signal occurs and very often you will not see all your entry criteria, but still price goes back to the moving average. Staying away from jumping in late and not trying to chase a trade is very important. Other times, all your criteria line up, but price still keeps on going against you. Not cutting your loss and adding to a loser is what mean reversion traders often do because they believe that the reversal is overdue.
Tip: Oscillators, such as the STOCHASTIC, often provide the wrong implications for mean reversion traders. Overbought and oversold scenarios are often used as reasons to enter counter-trend trades, whereas overbought prices often just signal a very strong trend – not an overdue reversal.
All these points highlight the complexity and the challenges for mean reversion trading and it becomes obvious why this style may not be suited for amateur traders, or traders who are still struggling with the mental aspect of trading. However, not all traders feel comfortable trading with a trend following strategy; it is therefore important that you audit yourself to find your perfect fit.
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3 comments.
Great article, thank you very much.
I find myself leaning more and more towards the mean reversion method without even realising it. So this has helped clarify a few things.
I can definitely relate to the following statement in the article… ‘Although most people prefer the trend-following approach, I never felt comfortable with the general trend-trading mindset and I started looking at mean reversion trading’
I always wondered why I found the trend following approach hard for me mentally. I would love to hear more about your mindset and methods you use to find your correct trading niche.
Leave a Reply Cancel reply.
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Mean Reversion Trading Strategy.
Mean reversion (MR) trading is a short term technique that takes advantage of a well-documented market anomaly whereby rapid short term price falls are often followed by a 'reversion' to the 'mean'.
Mean reversion is a mathematical system that is also applied for stock trading and investing. The theory behind it is that a stock's high and low prices are only temporary, and that a security's price will tend to revert towards an average price over time. So stocks that dip down are likely to bounce back up.
Mean reversion is about identifying the trading range for a share, and then calculating the average price using fundamental data (assets, earnings..etc). Mean reversion may look to be a more scientific system of selecting share buy and sell points than charting, because exact numerical values are derived from historical data to identify the buy/sell values, rather than attempting to interpret stock market price movements using charts (charting, also referred to as technical analysis).
Of course mean reversion trading is not just as simple as buying any share that falls! If you do that, you will of course lose money! You will need to use filters that narrow the tradeable universe of shares down to those that are most likely to exhibit this momentum behaviour, and combine this with sensible risk management and exit criteria.
When the stock is trading at less than the average price, the security is considered attractive for entering a 'buy trade', the expectation being of course that the price will rise. When the present market price is above the stock's average price, the stock's tendency is to fall and revert back to the mean. So in a nutshell, deviations from the average stock price are expected to revert back to the average all other things being equal.
In this strategy, traders commonly use moving averages of 50 or 100 days to establish whether a stock has overshooted or is trading short of the mean. While reporting services provide the averages, identifying the high and low prices for the study period under consideration is still necessary.
This trading strategy offers a method of picking off high probability, short term trades that usually present themselves in times of extreme market volatility. The strategy is aimed at absolute performance; it will not hold your funds in the market for long periods of time. It is focused on short term, targeted, aggressive trades. As the strategy is volatility based it is unaffected by the general trend in the market at that point in time.
When using the reversion trading strategy to trade it is very important to be careful as large dips may imply a change of fundamental factors which may not revert back to a 'mean'. This strategy is suitable for traders with a high risk tolerance, as trades are generally taken at times of high market volatility. Frequency of trades also tends to group around these times of market volatility; mean reversion is the type of system whereby you can truly call yourself a 'trader'.
The strategy works on purchasing stocks that have been heavily oversold. Time and time again we see buyers return with strength to quality stocks that are oversold. Your aim as a mean reversion trader is to time your entry into the market so that you are in the stock and profiting from the rising prices that the returning investors create.
Brenton Hill's Share Trading Story.
Ten years ago Brenton Hill barely knew anything about share trading and since then he has quit his full-time job as a mechanical engineer to earn a living buying and selling shares.
In September 2003, the 37 year old embarked on an exploration to learn about trading shares. After less than two years share trading and a couple of weeks before his second child was born he quit his job and started trading full-time.
'I had made enough from trading part-time for nearly two years to be confident I could trade for a living,' Hill said.
Using a mechanical share trading approach Hill has grown his float by over 200%* in three years.
When Hill describes the secret to his success he explains, 'The market is not out to get you it's just the market. To be a successful mechanical trader it is important to divorce yourself from the daily happenings in the market so that you consistently follow your system.'
This is exactly what Hill did during the July and August 2008 share market correction which saw many traders say goodbye to thousands of dollars. Fortunately Hill was able to make money during this market tumble using mechanical share trading systems and sticking to his trading rules even when the market kept going down.
Hill said, 'I gave back a fair chunk of my profit to the market in just one week and then regained this and more. I am well ahead again now.'
The trading style that Hill uses includes 12 systems which he trades in both the US market and on the ASX. The goal of some of these systems is to identify and buy falling stocks which have dropped significantly and are expected to rebound. This type of system is described as a mean reversion system.
'Mean reversion trading is the revolution to making money quickly. One trade made me 74%* in two trading days, but those kinds of results don't happen every week,' said Hill. Hill tests the performance of each system using historical data from the past 10 years. He refers to this form of paper-trading as backtesting. 'All of my systems would have performed successfully over the past 10 years according to my backtesting. These results give me confidence to trade shares in all market conditions. There are anxious moments but you must stick to your system rules to be successful,' he said.
Hill trades both equities and Contracts For Difference (CFDs) and he stresses that a stock must have sufficient liquidity before taking the trade. Based in the Adelaide Hills, he explains that he never envisaged himself as a share trader and being at home with his young kids everyday.
Remember that CFDs are geared and can result in losses that exceed your initial deposit. They may not be suitable for everyone, so please make sure that you fully understand the risks involved.
The content of this site is copyright 2011 Contracts for Difference Ltd. Please contact us if you wish to reproduce any of it.

Revert to mean trading strategy

The following article is sponsored by the Dr. Stoxx Options Letter.
In my two previous articles on this topic, I detailed how traders and investors use one of the most common components of technical analysis, the simple moving average. A moving average is a running average of the closing price of a stock over x number of time periods. The two most widely used averages are the 50day and 200day moving averages. Moving averages are not just used by specially trained market technicians. Even financial analysts with Harvard MBA’s will refer to the 50day and the 200day moving averages as frequently as they do to P/E ratios and earnings growth rates.
In the previous articles, I talked about how moving averages help us get a good “read” of a stock’s price chart. We’ve seen how to use moving averages to determine the dominant trend of a stock or index, as well as the ideal points at which to enter or exit that trend. Today I want to bring my discussion of moving averages to a close by talking about one more way to use moving averages. This is, in fact, the most profitable technical trading strategy I use. In this strategy we are stressing the idea that certain moving averages – particularly the “big two”, the 50day and 200day averages – act as “magnets” for the price of a stock or index whenever it moves too far away from the averages.
The phenomenon I am referencing here has a fancy label. It’s called “mean reversion”, and it recurs so often in financial markets that studying it and learning how to profit from it have become a kind of cottage industry. Some of the world’s greatest financial minds, including Ivy League professors and Federal Reserve Bank economists, have published peer-reviewed papers on the subject.
The idea behind mean reversion, in a nutshell, is this: a moving average of share price represents the accumulation of wisdom on the fair market value of a particular company’s shares (and hence, of the company itself), while the day to day fluctuation in share price is more a reflection of the ever changing whims of market sentiment. Thus whenever that sentiment drives share price too far from its average, the efficiencies of market forces being what they are, share price is bound to revert back to its mean in short order.
Determining just when price has been stretched too far from its average, and just how far back to the mean it will travel when it does revert, is more art than science. But there is one tool that can help us greatly with this determination. Using past price performance over X number of time intervals, this tool measures standard deviation from a moving average and draws bands on the chart, both above the below the average, that show the upper and lower limits of that deviation. It is expected that price will stay contained within these bands going forward. This would be “normal” price action. Any move above or below the bands, therefore, signals an “abnormal” move beyond the standard deviation, hence an overextension that is likely to revert to the mean.
The tool I’m talking about here, of course, is Bollinger Bands, developed by market technician, John Bollinger, back in the 1980’s. I’ve used these bands for years and can say that, like most technical indicators, they work well when they work! But when the Bollinger Bands are not working well, your trading based on them can go horribly wrong. Still, when we couple the Bands with stop-losses to minimize the damage, they are the best tool we have for determining regions of price extremes where a stock or index is likely to get over-extended and flip back to the mean.
Let me show you some examples. In the chart below you’ll see shares of EBAY, Inc. (Nasdaq: EBAY) with the 200day moving average overlaid, along with the upper and lower Bollinger Bands set at 1.5 standard deviations away from the average. You can see how over the past 9 months, whenever price travelled outside either band, it was only a matter of time before it bounced back the other direction.
I used a standard deviation of only 1.5 on the 200day moving average in the above chart because it takes a significant move to get even that far away from such a long-term moving average of price. When we shorten our time frame down to the 50day average, however, we’ll need to increase our deviation from 1.5 to 2.0 to reduce the noise of false signals.
Here is a chart of Amazon, Inc. (Nasdaq: AMZN) during a rather inefficient, tumultuous time in the stock’s recent history. I have here overlaid the 50day moving average with bands set at 2.0 standard deviations away from the average. You can see a greater number of signals compared to the chart above, and also that some signals would have been more profitable than others.
As you work with Bollinger Bands, you will want to refine your trading system. You cannot simply buy every dip below the lower Band and sell short every rally above the upper Band. As you experiment, I suggest integrating some of the following suggestions into your trading system:
Only take buy signals at areas of price support and sell signals at areas of price resistance Don’t trade minor moves beyond the Bands but only those that exceed the Bands by a certain percentage (you can use the %B Bollinger Band Indicator for this determination) Try entering only when price closes outside the Bands on one day, then closes inside the Bands on the next day Only take trades when Bands are wide and avoid trades when Bands are constricted.
Mean reversion theory is a well attested phenomenon that, when learned well and traded appropriately, can be a very profitable approach to the markets. If you are looking for more resources on this trading system, you might want to try the Mean-Reversion Trading Manual I offer on my website, DrStox. You can also look at my book, Market Neutral Trading, where I fully explain how I use this trading system. But certainly the original source is always a good place to start too: Bollinger on Bollinger Bands, the “bible” of the Bands!
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