Fama and French (1988) discuss two competing economic explanations of mean reversion in stock returns. Mean reversion can occur due to mispricing in an irrational market in which prices take long temporary swings away from fundamental values.
What is mean reversion in stock market?
Gordon is a Chartered Market Technician (CMT). He is also a member of CMT Association. 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.
What is mean reversion and why does it matter?
What is Mean Reversion? Mean reversion is a theory implying that asset prices and historical returns gradually move towards the long-termmean, which can be based on the economy, industry, or average return within a set of data.
What is the best mean reversion strategy?
Our best mean reversion strategy is to trade those price ranges that occur after a severe price markup or markdown. In this case, reversion to the mean implies trading around the middle of the range as our average price.
Do stock prices revert to the mean after a shock?
Instead of reverting back to the mean, stock prices may lead to a random walk post-shock. A random walk is a process when prices do not return to previous levels, nor do they gradually move towards the mean. For example, an increase in the momentum of the stock may lead to a greater deviation from the mean.
Why do stocks mean revert?
Stocks Tend to Mean Revert This is because outperformance tends to persist in the intermediate-term and reverse in the longer-term.
Do stock prices exhibit mean reversion?
152)." If divergences between market and fundamental values exist, but beyond some limit are eliminated by speculative forces, then stock prices will exhibit mean reversion.
Is mean reversion a good strategy?
An intraday mean reversion strategy works best when a strong trend is present, combined with a moving average where the price tends to get near it and then moves in the trending direction. It does not work as well when a strong trend is not present.
Why is volatility mean reverting?
Volatility is mean reverting if the underlying security doesn't drop to zero. If the security has some underlying "value" then its price is co-integrated with that "value". The volatility is the uncertainty of that price as it tracks the security's "value".
Why do commodity prices follow mean reversion?
If commodity prices are mean reverting, this is supposedly due to that producers adjust production to account for changing market conditions.
Is RSI mean reverting?
The 2 period RSI developed by Larry Connors is a mean reversion strategy which provides a short-term buy-sell signal. The strategy gives a probable buy signal when 2-period RSI goes below 10 (lower the better) which is regarded as highly oversold.
Which are mean reversion indicators?
One of the best technical indicators for mean reversion is RSI (Relative Strength Index) and I will often look at low values like RSI(2), RSI(3) or RSI(4). When RSI(3) is under 15, it is often a good place to enter a mean reversion trade.
Which moving average is best for mean reversion?
Time Frame. The time frame is extremely important when it comes to mean reversion. Just like various markets, each time frame has its own way of moving. In fact, I have discovered over the years that the 10 and 20 exponential moving averages work the best on the four hour and daily time frames.
Do hedge funds use mean reversion?
Many successful hedge funds and famous investors like Warren Buffett and Howard Marks have been able to use this long-term mean reverting dynamic to generate truly differentiated and noteworthy annualized returns over long periods of time.
What is mean reversion risk?
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.
What is mean reversion in time series?
A time series is mean reverting if it tends to fall when its level is above its long-run mean and rise when its level is below its long-run mean. If a time series is covariance stationary, then it will be mean reverting.
What is trend following strategy?
Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.
What is mean reversion?
Mean reversion is a theory implying that asset prices and historical returns gradually move towards the long-termmean, which can be based on the economy, industry, or average return within a set of data. The greater the deviation from their mean, the higher probability that the next movement of asset prices will be closer to the mean.
How do catalysts affect mean reversion?
How Catalysts Affect Mean Reversion. It is important to recognize that unexpected highs or lows can ultimately imply a shift in the nature of the stock, caused by events such as positive or negative news. For example, if news that Tesla just produced a new model is released to the public, there would likely be a positive shock in prices ...
What is random walk in stock market?
A random walk is a process when prices do not return to previous levels, nor do they gradually move towards the mean. For example, an increase in the momentum of the stock may lead to a greater deviation from the mean.
Do traders capitalize on catalysts?
Under the assumption that assets will revert back to their mean, many traders attempt to capitalize on catalysts that affect the price action of the stock. Thus, in terms of buying and selling, traders profit from upswings and prevent losses on downswings.
Is return of normal pattern always guaranteed?
Generally, returns of normal patterns are not always guaranteed, but it is indeed still possible for assets to experience mean reversion in the most extreme circumstances. Nonetheless, much like any event, it is difficult to fully determine how market activity for securities will be affected by the news.
What is mean reversion?
Mean reversion is a financial term for the assumption that an asset's price will tend to converge to the average price over time. Using mean reversion as a timing strategy involves both the identification of the trading range for a security and the computation of the average price using quantitative methods. Mean reversion is a phenomenon that can ...
What does it mean when a bankrupt is a mean reversion?
In finance, the term "mean reversion" has a slightly different meaning from "return or regression to the mean" in statistics.
What is mean reversion trading?
Put it simply; mean reversion trading assumes that over time the prices of any asset (stock, commodity, FX currency or cryptocurrency) in time will revert back to the mean or average price. In other words, reversion to the mean trading comes down to the old saying: “What goes up must come down.”.
Why is mean reversion trading more appealing?
The mean reversion trading systems are more appealing to a lot of traders because it tends to have a higher win rate as opposed to the trend following strategies. Even when the markets are in well-established trends, mean reversion happens quite often.
What indicator is used to determine extreme overbought price?
With mean reversion trading it’s critical to time the market. So here are some of the most popular tools you can use to time the market: RSI indicator can be used to spot extreme overbought price readings.
Is mean reversion better than day trading?
A lot of the times when you’re doing mean reversion trading, you’ll be quick in-and-out of a trade. That’s why day trading mean reversion strategy works better. There are other different ways to trade with the mean reversion strategy, including: Price stretch from a simple moving average strategy.
Is stretched valuations the only problem for the stock market?
Stretched valuations are not the only problem for the stock market. Rosenberg thinks that new Fed Chair Jerome Powell marks the end of low interest rates, which will also add pressure to equities.
Is it easy to find assets uncorrelated to the stock market?
Finding assets uncorrelated to the stock market is not easy. Generally, bonds do well, but they are reaching historical highs. Plus, they are threatened by rising interest rates and excessive US debt.
Why can't a stock revert to the mean?
For example, a single stock that just went initial public offering (IPO) cannot revert to the mean because it doesn’t have a price history. The stock needs time to establish its running average.
What is reversion to mean?
Reversion to the mean is used by traders who employ technical analysis to make investing decisions. But it’s important in other fields, too, so illustrating it can be done with examples outside of finance. Weather, for example, gives perhaps the most ordinary lived experience of a reversion to the mean.
What does volatility mean in the stock market?
Volatility can often indicate real information about the underlying assets. In fact, when the market is working efficiently, volatility usually indicates that something real has changed about the underlying assets. In that case there’s no good reason to expect a reversion to the mean. The Bottom Line.
Does the stock market have a running average?
The stock needs time to establish its running average. The stock market as a whole, on the other hand, has a long-running history. It has an average that it can return to, and so the market as a whole can revert to the mean after a period of volatility. In fact this is what investors saw during the volatility of 2020.
Can an asset fluctuate?
An asset’s price can fluctuate based on nothing but market activity. Investors can trade based on any number of technical factors that have nothing to do with the actual value of the underlying assets. In that case, reversion to the mean may very well be a good strategy.
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 strays far from the long-term norm or trend will again return, reverting to its understood state or secular trend. This theory has led to many investing strategie…
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. Mean reversion has also been used in options pricing to describe the observation that an asset's volati…
Limitations of Mean Reversion
- The return to a normal pattern is not guaranteed, as unexpected highs or lows could indicate a shift in the norm. Such events could include, but are not limited to, new product releases or developments on the positive side, or recallsand lawsuits on the negative side. An asset could experience a mean reversion even in the most extreme event. But as with most market activity, t…
Trading with Mean Reversion
- Generally, mean reversion is used as a statistical analysis of market conditions to determine a trading strategy. For example, from the perspective of investing, strategies that involve mean reversion are comparing stocks or other securities whose price-performance greatly contrasts its historical average. Applying that knowledge, investors are cap...
How Catalysts Affect Mean Reversion
- It is important to recognize that unexpected highs or lows can ultimately imply a shift in the nature of the stock, caused by events such as positive or negative news. For example, if news that Tesla just produced a new model is released to the public, there would likely be a positive shock in prices for a certain period of time before reverting to levels before the shock. The duration for w…
Random Walk
- Instead of reverting back to the mean, stock prices may lead to a random walk post-shock. A random walk is a process when prices do not return to previous levels, nor do they gradually move towards the mean. For example, an increase in the momentum of the stock may lead to a greater deviation from the mean.
Complementary Technical Indicators and Financial Information
- For traders, tools such as the Relative Strength Index (RSI)can be used to determine oversold or overbought price levels, which act as proxies to enter and exit mean reversion trades. Standard deviation, Bollinger Bands, and money flow are used to determine the distance away from the long-term average; therefore, these tools can be used to track unusual price movements. Regar…
Arguments Against Mean Reversion
- 1. Markets are efficient
Many individuals believe that markets reflect all available information and that it is impossible to outperform the markets unless insider informationis provided or some sort of illegal competitive edge’s been given. For example, if a stock increases by 30%, there should be a cause behind tha… - 2. Poor performance indicators
With mean reversion indicators, such as Shiller’s CAPE, it’s been argued that many similar tools were tested using insufficient sample sizes. Thus, their results would be ineffective against the entire market.
Arguments For Mean Reversion
- Although there are arguments against mean reversion trading strategies, many successful investors employed such an approach in the past and enjoyed a track record of success with it. Long-term investors, such as Warren Buffett, use a contrarian type of investing strategy, which is fairly similar to mean reversion. Hedge fund founder Jim Simons of Renaissance Capital used m…
More Resources
- CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: 1. Contrarian 2. Momentum Indicators 3. Chaikin Money Flow (CMF) 4. Directional Trading Strategies
What Is Mean Reversion Trading?
Mean reversion is a financial term for the assumption that an asset's price will tend to converge to the average price over time.
Using mean reversion as a timing strategy involves both the identification of the trading range for a security and the computation of the average price using quantitative methods. Mean reversion is a phenomenon that can be exhibited in a host of financial time-series data, from price data, ea…
How Mean Reversion Trading Works?
Why The Mean Reversion Strategy Works?
Mean Reversion Trading Strategy
Final Words – Best Mean Reversion Strategy
- With mean reversion, we’re looking to trade against the heard. A lot of the times when you’re doing mean reversion trading, you’ll be quick in-and-out of a trade. That’s why day trading mean reversion strategy works better. There are other different ways to trade with the mean reversion strategy, including: 1. Price stretch from a simple moving average strategy. 2. A break outside th…