Quick definition Mean reversion is a strategy that profits from the tendency of prices to return to their historical average. When a price is unusually high or low, it is expected to revert. What it is Mean reversion assumes that prices fluctuate around a long-term average. If a stock's average price is 100 dollars and it suddenly jumps to 120 dollars, the strategy assumes it will revert to 100 dollars. When the price is above average, the strategy sells (or shorts). When the price is below average, the strategy buys. Why it matters Mean reversion is one of the most profitable trading strategies. Many quantitative funds rely on mean reversion models. Mean reversion works because prices do exhibit reversion. Extreme moves are often followed by reversions. But mean reversion can fail if a price move represents a permanent shift in value (e.g., a company fundamentally improves). Mean reversion versus momentum Momentum trading profits from prices continuing to move in the same direction. Mean reversion profits from prices moving in the opposite direction. A price has just risen 10 percent. A momentum trader expects it to continue rising. A mean reversion trader expects it to fall back down. Measurement Mean reversion is measured by looking at autocorrelation (correlation of prices with their lagged values). Negative autocorrelation indicates mean reversion. Positive autocorrelation indicates momentum. Practical example A stock's historical average return is 0.1 percent per day. Over 20 days, it has returned 5 percent (0.25 percent per day), well above average. A mean reversion trader expects the stock to underperform for the next 20 days, bringing the total back to average. They short the stock, betting on reversion. Risks Mean reversion can fail if the fundamental value of an asset has changed. A new product launch might permanently increase value; mean reversion traders would short and lose. See also - Statistical Arbitrage - Pairs Trading - Momentum Trading - Overvalued
