Why does mean reversion work

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How can I switch accounts? CFD login. Personal Institutional Group. Log in. Home Learn Trading guides Mean reversion. Mean reversion Mean reversion is a financial theory which suggests that, after an extreme price move, asset prices tend to return back to normal or average levels. See inside our platform. Start trading Includes free demo account. Quick link to content:. What is mean reversion in trading?

Mean reversion formula To understand and calculate mean reversion, traders need to calculate the mean. Losing Trades 2. Average Hold in Trading Days 4. Every year was profitable in the test results from The day moving average, a filter we have applied for decades, still remains one of the better ways to tell you if the market is in a longer term bull market versus a bear market. So yes, since , If mean reversion was dead this would not have occurred.

In fact based on this one test, one could argue mean reversion has gotten even stronger. What we also did was look at other short-term mean reversion ETF index strategies we published.

What we found was that the majority of ETF mean reversion trading strategies continued to perform as well as they had over the previous 15 years. One additional note: We also looked at other major ETFs. This does not mean that momentum trading does not work. It simply means that if you are a swing trader, one who trades over a day period of time, there are an abundance of pullback strategies for liquid ETFs that you can apply to your trading which have large amounts of data to confirm that healthy edges have remained in place.

The RSI 25 Strategy is just one example that has proven this out. Enjoy your trading! The win ratio is normally very high, but often the distribution has more big losers than big winners.

Another key point about mean-reversion is high activity. To get a high CAGR you need to trade quite frequently. This is both positive and negative. The positive is that you normally can get faith in the system because of the big sample of trades. The drawback is, of course, slippage and commissions. However, the faith in a mean-reverting system can easily grind to a halt when you get the infrequent big loser.

The biggest risk in trend-following is that your account slowly bleeds to death. A mean-reversion strategy is more likely to deteriorate quickly. You can make a lot of money for over a year, only to see most or all of it disappear in a brief bear market. This means that mean-reversion and trend-following require completely different mindsets, risks, and drawdowns. The principles of mean reversion strategies are simple: you buy when something has fallen, and you sell when it has risen in value.

We end the article by presenting a bullet point list on how to develop a mean-reversion strategy:. Because mean reversion has worked so well in the stock market for over two decades, most indicators that buy on weakness and sell on strength have worked. We have covered many of these indicators and included examples and strategies in the articles. Our favorite indicators to make the best mean reversion strategies are these:. We have made many quantified mean reversion strategies over the years.

This is a friendly reminder of how you can sign up for this service:. They are both easy to understand, implement, and are for most traders easy to execute. However, it has its drawdowns: you cut the winners and let the losers run. Mean reversion is often intuitive: buy weakness and sell strengths.

Because of this, we recommend mean-revertive systems, as a matter of fact, most of our systems are mean-revertive, but you need to diversify to different time frames, instruments, and by using filters. How do you build or create a mean reversion strategy? You need to use the most important tool of any trader: statistics to quantify your hypotheses. Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional.

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About the site. Terms of use. Skip to content Last Updated on October 16, by Oddmund Groette How do you create or build a mean reversion strategy?

What is mean reversion in trading? One of the fundamental assumptions of many options pricing models is that an asset's price volatility is mean-reverting. As the figure below depicts, the observed volatility of a stock can spike above or drop below its mean, but always seems to be bounded around its average level. High-volatility periods are typically followed by low-volatility periods and vice versa. Using mean reversion to identify volatility ranges combined with forecasting techniques, investors can select the best possible trade.

Mean reversion trading in equities tries to capitalize on extreme changes in the pricing of a particular security, assuming that it will revert to its previous state. This theory can be applied to both buying and selling, as it allows a trader to profit on unexpected upswings and to save on abnormal lows. Those interested in learning more about mean reversion theory and other financial topics may want to consider enrolling in one of the best technical analysis courses currently available.

The return to a normal pattern is not guaranteed, as unexpected highs or lows could indicate a shift in the norm. Such events could include, but are not limited to, new product releases or developments on the positive side, or recalls and lawsuits on the negative side.

An asset could experience a mean reversion even in the most extreme event. But as with most market activity, there are few guarantees about how particular events will or will not affect the overall appeal of particular securities. Advanced Options Trading Concepts. Advanced Technical Analysis Concepts. Actively scan device characteristics for identification. Use precise geolocation data.