The Mean Reversion Strategy

REGRESSION TO THE MEAN

The mean reversion strategy is based on the assumption that extremely high and low prices which have been established in a relatively short time have deviated too much from the average price so that there is a high probability that there will be a fall back to the prevailing mean price (regression to the mean). It is primarily a statistical phenomenon that became known through the work of the British statistician Francis Galton, a half-cousin of the thirteen years older Charles Darwin.

An example that makes this phenomenon easily understandable is the tossing of coins. When you flip a coin, in theory there is an equal chance that the coin will land heads or tails (50%). In reality, however, you will find that this is rarely the case. After ten, twenty or thirty tosses, the odds of ending up with heads or tails may be 60/40 or even 80/20. The fact is that the greater the number of consecutive throws, the more the curve will move towards 50/50.

However, it is important to realize that when it comes to stock price movements, the average in itself can, of course, be either rising or falling. A return to the average should therefore not be confused with a real trend reversal or with a price development that is neutral in any case. A rising price which, after a strong run up, drops to the level of its 20-day average, is also an example of "regression to the mean".

Price movement towards 20-day average after price extreme

Using the Bollinger Bands indicator, price extremes are identified when the stock rises above the upper bollinger band or below the lower bollinger band

Mean reversion strategies are especially interesting for day and swing traders. It comes down to finding the stocks that deviate the most from their average price, especially when those extreme deviations coincide with significant support or resistance zones. In this way, some interesting low risk entries can be found.

Converging elements: price extreme above upper bollinger band and at resistance price level

IN A NUTSHELL

Mean reversion strategies are totaly opposite to trend strategies, just because they completely go against the prevailing trend and try to speculate on a countermove in the existing trend. These are often used in swing trading.

However, remember that once the price extreme is restored the existing trend may still be intact. Thus, the time frame in which you operate with such a strategy is much shorter and the style of trading is quite a bit more aggressive.