Mean reversion is a trading strategy based on the assumption that asset prices tend to revert to their mean or average over time. It is used by traders and investors alike, who seek to capitalize on the inherent fluctuations in prices.
This article will provide a basic guide to understanding mean reversion, its key principles, and how to develop a trading strategy around it that you can build from if it suits your objectives and style.
Understanding Mean Reversion
Mean reversion is grounded in the belief that financial markets are inherently cyclical, with periods of overvaluation and undervaluation. The concept is rooted in the law of averages, which states that over time, extreme outcomes will balance out, resulting in an overall average value.
In the context of trading, mean reversion suggests that when asset prices deviate significantly from their long-term mean, they are likely to revert back, providing traders with potential opportunities to profit. This reversion can be attributed to various factors, such as market sentiment, economic indicators, or fundamental changes in the underlying asset.
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