What is Mean Reversion?
Mean reversion is the theory that prices and returns tend to move back toward their historical average or mean over time, suggesting that extreme price movements are usually followed by a return to normal levels.
Mean Reversion Explained
Mean reversion traders look for assets that have deviated significantly from their average price and bet on a return to that average. Common tools include Bollinger Bands, moving averages, and RSI. This strategy works best in range-bound markets and can be dangerous in strongly trending markets where prices can deviate from the mean for extended periods.
Real-World Example
A stock that typically trades between $40 and $60 drops to $35 on a temporary panic. A mean reversion trader buys at $35, expecting the price to return to the $40-60 range. They set a target at $50 (the mean) and a stop at $30.
Related Terms
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