All traders know it: operational strategies are fundamental to give effectiveness to one's trading action. Some are based on the ability to follow trends, while others are based on the possibility of identifying moments of reversal. Among the latter, a prominent place is occupied by
the mean reversion strategy, a methodology that originates from statistical concepts and over the years has found practical application in financial markets.
We discuss it here. We will explain what mean reversion is, how it is concretely used, and what are the main advantages and limits related to its adoption.
What is mean reversion
Mean reversion, literally "return towards the mean," is first and foremost a theory. It suggests that assets tend to oscillate around a long-term average value. In other words, if a price deviates too much from the historical average, it is likely that
over time it will return towards that level.
This concept is borrowed from statistics and econometrics, but it has been transposed to trading to develop buying and selling strategies based on the same assumption:
market excesses are not sustainable in the long term.
More specifically, markets can experience moments of euphoria or panic that push prices beyond values considered "fair." However, such deviations
do not last forever, and sooner or later, equilibrium is restored.
This is where the mean reversion strategy seeks to exploit these phases of deviation,
betting on a return towards average values.
A simple example is the price of a stock that, compared to its 20-day moving average, suddenly finds itself
much higher or much lower. The logic of mean reversion suggests that it is only a matter of time before the price converges back with the average.
Pay attention: the application of this strategy is not trivial and requires
a medium-high level of competence. It is not just a matter of calculating an arithmetic mean, but of carefully selecting the most suitable statistical tools, evaluating volatility, recognizing periods of sideways markets compared to strongly directional ones, and understanding the nature of the financial instruments being traded.
How to use mean reversion
In light of this, it is important to explain how to use it properly.
Basically, it involves identifying situations where the price of an asset deviates significantly from a predetermined average value. This average can be calculated in different ways: through simple
moving averages, exponential moving averages, or more complex indicators that also incorporate volatility, such as Bollinger Bands.
But here are the main steps:
- Asset selection: a financial instrument with sufficient liquidity and data historicity is selected.
- Calculation of the reference average: an appropriate time horizon is established (for example, a 20-period moving average).
- Definition of deviation thresholds: the levels beyond which the price can be considered "excessively high" or "excessively low" are determined.
- Identification of the signal: when the price deviates significantly from the average, an operational signal is generated.
- Trade execution: a position is entered betting on a return to the mean.
Let's now make a practical example.
Let's consider a hypothetical stock XYZ, trading at 100 euros. Its 20-day moving average is 95 euros, with a standard deviation of 3 euros.
If the price suddenly rises to 105 euros, the trader could interpret this condition as a bullish excess. Based on mean reversion, the price will tend to revert
towards the average of 95 euros. The operation in this case would consist of a short position at 105 euros, with a target close to 95 euros.
If, on the other hand, the price drops to 88 euros, the trader could read the situation as a bearish excess. The logic of mean reversion suggests a possible return towards 95 euros. The operation would therefore consist of a long purchase at 88 euros, aiming to close the operation near 95 euros.
No strategy can disregard proper risk management, and mean reversion is no exception. In both cases just mentioned, it would be essential to establish
a stop loss, for example set at the exceeding of two standard deviations from the mean, to limit losses if the market continues to move in the opposite direction.
Pros and cons of mean reversion
Like any other trading strategy, mean reversion also has advantages and disadvantages. It is a matter of understanding the two sides of the coin and deciding if and how to integrate it into one's operational approach.
The advantages
One of the main strengths is its
theoretical solidity. As already mentioned, mean reversion is based on observable statistical principles and frequent market dynamics: prices, in most cases, do not indefinitely deviate from their average values.
A further advantage concerns the possibility of
exploiting sideways markets. While trend-following strategies tend to suffer when the market moves within a range, mean reversion finds itself perfectly at ease in such conditions, thus allowing for regular profits even in the absence of marked directions.
Another positive element is
flexibility. The strategy can be applied to different assets (stocks, bonds, currencies, commodities) and adapted to different time horizons, from day trading to medium-term positioning.
The disadvantages
Among the main limitations, it is necessary to mention the low effectiveness in strongly directional markets. When a trend is robust and sustained by macroeconomic or fundamental factors, the price can remain distant from the average for long periods, rendering the strategy ineffective and increasing the risk of losses.
Another disadvantage is the
need for high technical skills. It is not enough to calculate a moving average: it is necessary to know how to distinguish false signals, manage volatility, select the most appropriate time horizon, and adapt the strategy to different market conditions.
Mean reversion can also generate
an unfavorable risk/return ratio. Often the gains are limited, as the aim is a return towards average values, while potential losses can be high if the market does not retrace as expected.
