What Is Mean Reversion?

Mean Reversion Trading Explained

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Mean reversion is a principle used in investing. It states that any extreme fluctuation in price will return to its normal and expected state.

For investors, this means that large or unexpected fluctuations of prices in either direction can be expected to return (eventually) to their long-term, average growth.

What Is Mean Reversion?

Mean reversion, or reversion to the mean, is a statistical principle that can be used in finance and investing. It states that volatile prices and historical fluctuations will eventually return, or revert, to the long-term average, or mean, of a dataset.

For investing, this means that extreme, unexpected fluctuations in stock prices don't last. Eventually, prices should return to their average growth curve.

Essentially, price is seen as being like a rubber band: if it is stretched too far in either direction, at some point it will abruptly snap back to its previous position.

Mean reversion is a theory that focuses on extreme or unexpected swings in prices. Smaller changes in price, in both directions, are expected parts of the stock market.

How Mean Reversion Works

In investing, mean reversion can apply to individual stocks experiencing price fluctuations or to outliers within an industry.

  • Time series mean reversion: The value of a single variable reverts back to its historical average. This applies to individual stocks experiencing price fluctuations.
  • Cross-sectional mean reversion: The value of a variable reverts back to its cross-sectional average. This can be used when comparing stock prices across a single industry and looking at outliers.

For example, if most hotel stocks are trading at an average of $50 per share, but one suddenly and unexpectedly begins trading at $300, mean reversion would predict that the outlier stock will eventually revert to the industry average.

How to Use Mean Reversion Indicators When Trading

For investors, using mean reversion as an investing theory can lead to different decisions, depending on individual goals. For example, investors may decide to:

  • Buy previously valuable stocks that have recently experienced extreme price drops, based on the assumption that the price will return to average.
  • Sell stocks that have experienced a sharp increase in value based on the assumption that the price will go back down.
  • Hold on to stocks experiencing negative price fluctuations, with the expectation that the fluctuation will not last and that prices will return to normal,

However, mean reversion should not be the only indicator you use to make investing decisions. In many cases, it may not be the best one for helping you time the market or make smart trades.

Other Common Trading Indicators

Snapbacks to an appropriate price that mean reversion predicts can be important market indicators. However, there are times when they should and should not be considered in your investing decisions.

There are other indicators that investors can rely on to help spot trends or changes in the market.

Overbought/Oversold

When traders refer to stocks being "overbought" or "oversold," they’re often referring to how an oscillator is performing on a chart. An oscillator tool helps you show whether a specific currency pair is continuing to close near the top or bottom of its multi-period range.

One popular oscillator is the Relative Strength Index, created by Welles Wilder. The oscillators travel between zero and 100. Levels between 70 and 100 are seen as aggressively overbought markets, whereas levels below 30 are seen as aggressively oversold markets.

Using this indicator suggests selling on a bullish breakout and buying on a bearish breakout. However, when trading this manner, you should be looking for extremes to rejoin the trend.

An uptrend has you focusing on oversold signals to buy in the direction of the larger trend, whereas a downtrend has you focusing on overbought signals to sell in the direction of the larger trend.

Bullish and Bearish Divergence

Divergence happens when price and momentum are not in sync. Traders are looking to see whether the price is moving higher on weaker and weaker momentum or moving lower after an extended period of weaker and weaker momentum for the possibility of a mean reversion opportunity.

When momentum slows down against a larger move higher or lower, the subsequent break against the trend can be very aggressive, and that’s what traders are looking to trade. However, momentum can stall for long periods of time without a break.

One example comes from the S&P 500, where momentum has been slowing down, but the price continues to flirt within a few percentage points of all-time highs. Mean reversion traders will look at markets like this for an opportunity to catch that first aggressive move toward an average level or price.

Whether or not divergence is bullish or bearish depends on what the market has been doing before the momentum.

  • Bullish divergence happens when price continues to move lower after an extended period, but momentum starts to move higher. It is often a signal to traders that the old move is done, and a kickoff against the prior trend is about to happen.
  • Bearish divergence happens when price is moving higher, but a technical indicator is moving lower. This often points to lower prices in the future.

No matter what indicators you use, investing decisions should never be made on a single piece of information. Before buying or selling any equities, you should also consider factors like:

  • The underlying value of the company
  • The stability of the industry
  • Broader economic trends
  • Your long-term investing goals
  • Your personal risk tolerance

Key Takeaways

  • Mean reversion is a principle used in investing. It states that any extreme fluctuation in price will return to its normal and expected state.
  • For investing, this means that extreme, unexpected fluctuations in stock prices don't last. Eventually, prices should return to their average growth curve.
  • Mean reversion can be used to predict changes in price for a single stock that is experiencing extreme fluctuations or to compare outliers to the average stock price within an industry.

The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.