Mean reversion is the principle that prices extreme away from their average tend to move back. A stock trading at all-time highs relative to fundamentals is a reversion candidate. Mean reversion strategies identify these extremes and profit from normalization.
The Theory Behind Mean Reversion
Prices deviate from intrinsic value through supply/demand imbalances. When stocks become too expensive, selling accelerates. When prices fall too far, value buyers emerge. Prices oscillate around their mean. This oscillation is quantifiable and tradeable.
Reversion happens on multiple timescales: intraday bounces, weekly corrections, seasonal patterns, multi-year normalizations. Each requires different signal definitions and holding periods. Shorter-term reversions offer more frequent trades but smaller expected returns per trade.
Identifying Mean Reversion Opportunities
Statistical deviation from moving averages is one signal. When prices move 2 standard deviations from their 50-day average, reversion probability increases. The farther the deviation, the stronger the reversion signal. But deviation magnitude alone isn't sufficient.
Velocity matters. Fast moves provide stronger signals than slow gradual moves. A stock that drops 20% in one day is a stronger reversion candidate than one dropping 20% over six months. Momentum and mean reversion often work together: large momentum reversions offer the best opportunities.
Execution and Position Management
Mean reversion trades often require rapid execution. The first counter-move signals position entry. Holding periods are measured in days to weeks. Exit rules matter as much as entry rules. Exit when the position reverts to target levels or when time-based stops are hit.
Position sizing requires care. Reverting positions can move against you before reversing. Adequate stops and position sizing prevent catastrophic losses. Position size inversely proportional to distance from mean ensures proper risk management.
Regime Dependence and Limitations
Mean reversion fails in strong trending markets. A stock making new highs doesn't revert; it trends. Regimes with persistent momentum overwhelm mean reversion signals. Effective strategies detect regime changes and adjust position sizes accordingly.
Structural changes create false signals. A company experiencing fundamental deterioration doesn't revert to previous valuations. Mean reversion assumes price extremes are temporary. Always verify that fundamentals support reversion expectations.
Educational content only. Not investment advice.