Mean reversion
Encyclopedia
Mean reversion is a mathematical concept sometimes used for stock investing, but it can be applied to other assets. In general terms, the essence of the concept is the assumption that both a stock's high and low prices are temporary and that a stock's price will tend to move to the average price over time.
Mean reversion involves first identifying the trading range for a stock, and then computing the average price using analytical techniques as it relates to assets, earnings, etc.
When the current market price is less than the average price, the stock is considered attractive for purchase, with the expectation that the price will rise. When the current market price is above the average price, the market price is expected to fall. In other words, deviations from the average price are expected to revert to the average.
The standard deviation
of the most recent prices (e.g., the last 20) is often used as a buy or sell indicator.
Stock reporting services commonly offer moving averages for periods such as 50 and 100 days. While reporting services provide the averages, identifying the high and low prices for the study period is still necessary.
Mean reversion has the appearance of a more scientific method of choosing stock buy and sell points than charting, because precise numerical values are derived from historical data to identify the buy/sell values, rather than trying to interpret price movements using charts (charting, also known as technical analysis
).
Some asset classes, such as exchange rates, are observed to be mean reverting; however, this process may last for years and thus not of value to an investor.
Mean reverting should demonstrate a form of symmetry since a stock may be above its historical average approximately as often as below, as predicted by the efficient-market hypothesis. However, saying that a stock is 'overpriced' is a rare statement, since mean reversion is a useful tool for those who wish to sell you stocks.
A mathematically mean reverting process would not demonstrate the observed and common phenomenon that a stock price may hit zero and stay there.
Mean reversion involves first identifying the trading range for a stock, and then computing the average price using analytical techniques as it relates to assets, earnings, etc.
When the current market price is less than the average price, the stock is considered attractive for purchase, with the expectation that the price will rise. When the current market price is above the average price, the market price is expected to fall. In other words, deviations from the average price are expected to revert to the average.
The standard deviation
Standard deviation
Standard deviation is a widely used measure of variability or diversity used in statistics and probability theory. It shows how much variation or "dispersion" there is from the average...
of the most recent prices (e.g., the last 20) is often used as a buy or sell indicator.
Stock reporting services commonly offer moving averages for periods such as 50 and 100 days. While reporting services provide the averages, identifying the high and low prices for the study period is still necessary.
Mean reversion has the appearance of a more scientific method of choosing stock buy and sell points than charting, because precise numerical values are derived from historical data to identify the buy/sell values, rather than trying to interpret price movements using charts (charting, also known as technical analysis
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
).
Some asset classes, such as exchange rates, are observed to be mean reverting; however, this process may last for years and thus not of value to an investor.
Mean reverting should demonstrate a form of symmetry since a stock may be above its historical average approximately as often as below, as predicted by the efficient-market hypothesis. However, saying that a stock is 'overpriced' is a rare statement, since mean reversion is a useful tool for those who wish to sell you stocks.
A mathematically mean reverting process would not demonstrate the observed and common phenomenon that a stock price may hit zero and stay there.
See also
- Convergence tradeConvergence tradeConvergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal , and...
- Pairs tradePairs tradeThe pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy...
- Ornstein–Uhlenbeck process
- NYMEX Natural Gas is a great example of Mean reversion