Mean Reversion Trading Strategy: Definition

Mean reversion trading strategy is a technique that traders use to buy and sell securities in order to take advantage of mean reversion. Mean reversion refers to the tendency for prices over time to move towards their average or normal level, with deviations from the trend happening as a result of outside influences. The technique requires continuous monitoring and following of price trends which can be very difficult. For this reason it is best used by algotrading systems rather than individual investors who have less time available for this task.

• In finance, mean reversion refers to the tendency for various phenomena of interest such as volatility returns, asset prices, price to earnings ratio (P/E) to return to their long-term average levels.
• Many investment methods have been developed as a result of the mean reversion strategy. This shows that is an effective way of trading financial assets.
• Mean reversion trading attempts to profit from significant price fluctuations in a particular security, relying on the assumption that it will revert to its previous condition.

What is Mean Reversion?

The term "regression to the mean" refers to the likelihood that an unidentified population may revert back to its mean. For example, when a stock is three standard deviations off its 20-day mean, this shows that there is a big chance that it will move back to its mean.

People have devised a variety of techniques for making money off using a mean reversion trading strategy.They anticipate that the extreme rate will return to the average, whether it is a financial instrument's volatility, interest rate, or economic growth indicator. According to the conventional wisdom, large fluctuations in price are difficult to maintain for extended periods.

Limitations of Mean Reversion

Although a return to normalcy is not assured, unexpected highs or lows might signal a change in the pattern. No one knows what the future holds and how rapidly markets might react to new developments. We should evaluate and attempt to reduce the risk or drawdowns of our algorithm, just like we would with any other type of algorithmic trading strategy.

A mean reversion in an asset's value is possible even in the most extreme scenario. However, as with other market activity, there are few certainties about how particular events will or will not influence the general appeal of specific equities.

When to Use Mean Reversion Trading Strategy

The mean reversion strategy is best used in the following situations:

• Oscillations in prices, without a clear trend, are best suited for mean reversion.
• The following are three factors that may identify market anomalies: high volatility, stationary time series, and negative autocorrelation.
• Select the mispriced stock and take advantage of market inefficiencies.

In the following posts, I'll try to develop a mean revertion strategy using python. I will backtest the algorithm in individual stocks, crypto or FX, and identify which types of assets are the best fit for this sort of approach. Follow me on the journey of finding alpha.