Mean Reversion - Explained
What is a Mean Reversion?
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Table of ContentsWhat is Mean Reversion?How Does Reversion to the Mean Work?Using the Mean Reversion Theory
What is Mean Reversion?
Usually, mean reversion is a financial indicator stating that asset prices and historical returns will return to their mean or its average in due time. This mean or average may refer to the historical average of the price, returns or another average, for example, the economic growth or the average return of an industry. Over time, this strategy has been deployed in stocks trading and options pricing.
- Mean reversion indicates whether prices or returns will rise or fall in the long term
- It specifies that prices that have risen over the long term will revert to its lower state.
- This system has been deployed as a stock trading strategy
How Does Reversion to the Mean Work?
Mean reversion or reversion to the mean extensively refers to the reverting process of any condition to its previous state. In other words, mean reversion refers to prices that have risen over a long period of time reverting to its initial state. This theory has resulted in numerous investing strategies involving buying and selling stocks or other financial assets whose recent performances have drastically changed from their historical averages. This change in returns could be an indicator that the company does not have the same prospects as before. Mean reversion is specifically focused on reverting securities that have undergone extreme changes, likewise, other assets whose growth is normal or rises and falls are part of the change. Mean reversion affects percent returns and prices, interest rates, price earning ratio of a company, etc. It is also used in options pricing theory to describe the observation that an asset's volatility will rise or fall over a long time frame.
Using the Mean Reversion Theory
Mean reversion trading views extreme changes that have occurred on the pricing of particular security as an opportunity that the price will revert or decrease to its former or normal state. This method allows a trader to benefit from this unexpected decrease or fall. The reversion theory is a statistical analysis of market conditions and is also seen as an insight into a worthy trading strategy. It is typically described as buying at a lower price and selling at a higher price. It aims at identifying an abnormal market activity that will revert to a normal pattern. This return to a normal pattern is not certain as an unexpectedly high or low could be an indication of a shift in the norm. This could be caused as a result of new product launch or developments on the positive side while it could be recalls and lawsuits on the negative side. It is possible that security, in the long run, will experience mean reversion, this is as a result of market activities. As common in the market, there are different events that may affect the overall appeal of specific security and this, in turn, leads to a Mean reversion on the security.