A theory used in finance to suggest that asset price volatility and historical returns will eventually return to the long-term mean or average level of the entire dataset is mean reversion, or reversion to the standard. This mean level may appear in several contexts, such as economic growth, a stock’s volatility, or an industry’s average return. Reversion to the mean is a process whereby a condition is returned to its long-term average. This concept assumes that the deviation from a long-term trend or norm will return to an established state or secular trend. The mean reversion theory may be used with a general trading strategy as part of the statistical analysis of market conditions.
Attempting to determine abnormal transactions that will revert to the natural order can be helpful for those who wish to buy lower and sell higher. By assuming that prices will eventually return to their mean or average values, mean reversion trading strategies aim to profit from price or stock market fluctuations. The principle is that extreme price movements are transient, and price cycles tend to occur. To practice your mean reversion strategy with virtual funds, open demat account that offers a demo trading platform. Here are a few commonly used mean reversion trading strategies mentioned in this article.
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What Does Mean Reversion In Trading?
Mean reversion in trading theorizes that prices tend to return to average levels, and extreme price moves are hard to sustain for extended periods. Many methods to exploit the theory have been developed by traders participating in mean reversion trading. They all bet that an abnormal level, whether it’s volatility, prices, growth, or a quantitative indicator, would return to the average.
Different Mean Reversion Trading Strategies
1.Systematic arbitrage:
This strategy uses statistical models to detect mispricing or differences in historical relationships between securities. Investors seek pairs of traditionally stable securities, e.g., two stocks in a given sector, so they take different positions when their relationship deviates from the norm. The aim is to capture profits as the relationship reverts to its mean.
2. Mean reversion based on fundamental analysis:
Fundamental factors, such as earnings, valuation ratios, or economic indicators, can identify overvalued or undervalued stocks relative to their historical averages. The trader may assume that the market will eventually adjust a stock’s price in such a way as to take into account its inherent value.
3. Pairs trading:
The strategy identifies the two highly correlated stocks and places them simultaneously in long and short positions. When the price spread between the two stocks widens significantly, you would short the outperforming stock and go long on the underperforming stock, expecting the space to narrow eventually.
4. Mean reversion based on technical indicators:
Traders can use technical indicators, such as Bollinger Bands or the Relative Strength Index (RSI), to identify overbought or oversold conditions in a stock. Traders can take positions against the current trend, anticipating a return to the mean when a stock’s price moves too far from its average or reaches extreme levels.
5. Mean reversion based on sector rotation:
This strategy involves monitoring the relative performance of different sectors within the stock market. Traders are targeting industries that have been outperforming or lagging and taking positions to benefit from an expected reversal in relative performance over time.
Mean Reversion Trading System
A trading platform with mean reversion tools, e.g., regression lines, moving averages, MACD, or PPO indicators, and the ability to compare assets between pair transactions is required for a trading system that relies on mean reversibility.
Conclusion
A useful market concept is a mean reversion but does not guarantee profitable trade. Although prices return to the mean over time, we must determine when. For longer than anticipated, prices can continue to move out of line with the mean. Likewise, the direction of the trend can be changed, as can how much or little price movement is possible. Just because a price has risen doesn’t mean it will fall to the mean; the mean could also grow to meet the cost.
The majority of professional traders have strict risk management protocols due to these unknowns. To minimise losses as far as possible, they will be able to indicate an exit point at which their position is closing out if the price does not deviate in its intended direction. To minimise losses, most traders follow the strategies listed above in this article for safe and secure trading as well as open a demat account with a trusted demat app for Android like blinkX. This app offers all the various tools and services required for successful and profitable trading.
