What is Mean Reversion?
Mean reversion is a financial concept that describes the tendency of a stock or index price to return to its average or "mean" value after deviating from it. This phenomenon is based on the idea that extreme price movements, whether upwards or downwards, are often temporary and unsustainable in the long run.
Think of your daily commute. Imagine if your average commute took one hour to complete. Depending on traffic, you may experience longer-than-average delays; on other days, when traffic is light, it may take you less than average. Over time, with enough samples, your commute tends to revert to the average of 60 minutes.
Stocks tend to do this as well. We see these deviations in individual securities/stocks as well as asset classes or categories. Using technical analyses while tracking 30-day, 60-day, or 120-day moving averages, traders who employ mean reversion strategies can try to capitalize on these temporary price deviations. They believe that when a stock moves significantly away from its average, it presents an opportunity to profit from its eventual return to the mean.
Mean Reversion Strategies in Practice
Mean reversion strategies are often implemented using technical indicators that help identify overbought or oversold conditions. These indicators include:
RSI (Relative Strength Index)
The RSI is an oscillator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. It fluctuates between 0 and 100. A high RSI value (typically above 70) suggests the asset is overbought, while a low RSI (typically below 30) indicates oversold conditions. Traders using mean reversion might buy when the RSI is low, anticipating a price rebound, or sell when the RSI is high, expecting a price correction.
Bollinger Bands
Bollinger Bands consist of a moving average and two standard deviations plotted above and below the moving average. These bands widen during periods of high volatility and contract during periods of low volatility. A stock price moving outside of the Bollinger Bands can signal an overextended move, suggesting a potential mean reversion opportunity. Traders might sell when the price touches the upper band, expecting a pullback, or buy when it touches the lower band, anticipating a bounce.
Stochastics
Similar to RSI, the Stochastics oscillator is used to identify overbought and oversold conditions. It compares a stock's closing price to its price range over a given period. Traders might use the Stochastics oscillator in conjunction with other indicators to confirm mean reversion signals.
Consecutive Bars
Another simple yet effective indicator is the number of consecutive up or down bars. This indicator helps identify extreme price moves in one direction, which might signal a potential reversal.
Internal Bar Strength (IBS)
IBS measures where a stock's closing price falls within the day's price range. A high IBS indicates that the closing price is near the day's high, while a low IBS signifies a close near the day's low. This information can be used to identify potential overbought or oversold conditions.
Challenges and Considerations
While mean reversion strategies can be profitable, they also carry certain risks and limitations. Starting from:
Identifying the mean
Determining the appropriate "mean" for a particular stock or index can be challenging. Different timeframes and calculation methods can yield varying results.
Trend Days
Mean reversion strategies tend to be less effective on trend days, where the market exhibits a strong directional bias. On such days, the price might continue to move in one direction, defying mean reversion expectations.
Stop-Loss Orders
Implementing stop-loss orders is crucial to manage risk in mean reversion trading. These orders automatically sell a position if the price moves against the trader's expectations, limiting potential losses.
Psychological Factors
Mean reversion trading can be psychologically demanding. It often requires buying when the market is falling or selling when the market is rising, which goes against the common instinct to follow the trend.
Conclusion
Overall, mean reversion is a valuable concept that can be incorporated into trading strategies. However, it's essential to understand its limitations and use appropriate risk management techniques. Combining mean reversion indicators with other technical analysis tools and a sound understanding of market dynamics can help make more informed decisions. Keep in mind that I do not recommend these strategies to the majority of investors. Most of us are long-term investors intending to play the long game to succeed and meet our financial goals. My intent in sharing these strategies is simply to educate part of the investment world.
If you need any assistance on your financial journey, walking through Dave Ramsey’s Seven Baby Steps, or need a deep dive into your financial/investment plan, reach out to a member of our financial advisor team. They are always ready to help with the heart of a teacher to help educate and create a plan to help you reach your financial goals.
Understanding Mean Reversion in Trading
December 19, 2024
Summit Puri
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