The Mean Reversion Strategy

Mean Reversion is the tendency for a price or return that has deviated greatly to move back toward its long-term average.

The strategy's idea is to 'fade the extremes.' If a price is excessively below the average, it is seen as bound to rise eventually, and if excessively above, as bound to fall. Here, the 'average' means a reference line such as a moving average, a past average price, or fair value.

In this respect, mean reversion is the exact opposite viewpoint from momentum and trend following, which hold that 'trends persist.'

There are two concepts often mentioned when judging mean reversion. (These are introductions for understanding only, not trading signals.)

RSI (Relative Strength Index): an indicator created by J. Welles Wilder in 1978, taking values between 0 and 100. Above 70 is commonly called overbought (risen too much) and below 30 oversold (fallen too much).

Bollinger Bands: bands drawn above and below a 20-day moving average (the middle line) by twice the standard deviation. They come from the assumption that statistically about 95% of prices stay within these bands. When the price touches the upper band, it is read as having risen a lot; when it touches the lower band, as having fallen a lot.

The biggest pitfall of mean reversion is that 'what looks cheap can get cheaper.'

In a strong downtrend, an asset that has already fallen a lot may keep falling further. It can become a situation of catching a falling knife with your bare hands. Conversely, in a bull market, 'overbought' can persist for a long time and keep rising.

Also, no one can guarantee when, or whether, it will actually return to the mean. It may stay far from the mean for a long time, and there are cases where the 'mean' itself shifts, such as an industry structural change (a regime change). That is why mean reversion carries the exact opposite risk of trend following.