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What is Mean Reversion?
Mean reversion is a financial and statistical concept suggesting that asset prices, economic indicators, or data series tend to move back toward their long-term average over time. It forms the basis of several trading, forecasting, and risk‑management strategies.
Definition
Mean reversion is the tendency of a variable—such as price, return, or volatility—to return to its historical average after deviating from it.
Key Takeaways
- Assumes extremes are temporary and will revert to normal levels.
- Commonly used in quantitative finance and time‑series analysis.
- Helps identify overbought or oversold conditions in markets.
Understanding Mean Reversion
Mean reversion is rooted in the observation that many economic and financial variables experience temporary fluctuations but ultimately drift back toward a long‑term trend or average. In markets, analysts use mean reversion to determine when an asset may be mispriced.
If an asset rises far above its historical average, mean reversion theory suggests it may decline in the future. Conversely, if it falls too far below its average, it may rise again.
However, not all variables revert to the mean—structural changes, shocks, and new market regimes can cause long‑term shifts. Therefore, mean reversion works best in stable environments or for variables with strong historical continuity.
Formula (If Applicable)
A common model used to express mean reversion is the Ornstein–Uhlenbeck Process:
Xₜ = μ + (Xₜ₋₁ − μ)(1 − θ) + ε
Where:
- μ = long‑term mean
- θ = speed of reversion
- ε = random shock term
Real-World Example
In stock trading, pairs trading strategies rely on mean reversion. If two historically correlated stocks diverge in price temporarily, traders may buy the undervalued stock and short the overvalued one, expecting prices to realign.
Importance in Business or Economics
Mean reversion helps investors identify mispriced assets, evaluate volatility, and build quantitative strategies. In economics, it is used to analyse inflation, interest rates, GDP cycles, and commodity prices that tend to normalise after shocks.
Types or Variations
- Price Mean Reversion: Asset prices return to historical averages.
- Volatility Mean Reversion: Volatility tends to normalise after spikes.
- Economic Mean Reversion: Macroeconomic variables return to trend levels.
Related Terms
- Time Series Analysis
- Volatility Clustering
- Regression to the Mean
Sources and Further Reading
- CFA Institute – Quantitative Concepts: https://www.cfainstitute.org
- Investopedia – Mean Reversion: https://www.investopedia.com/terms/m/meanreversion.asp
- Federal Reserve Economic Data (FRED): https://fred.stlouisfed.org
Quick Reference
- Prices and indicators tend to return to long‑term averages.
- Used for forecasting and quantitative trading.
- Not all variables revert—structural changes may break patterns.
Frequently Asked Questions (FAQs)
Does mean reversion always work?
No. Structural changes, disruptions, and new market cycles can prevent reversion.
What markets use mean reversion?
Equities, bonds, commodities, currencies, and volatility products.
How do traders use mean reversion?
How do traders use mean reversion?
To identify overvalued or undervalued positions and structure statistical arbitrage strategies.
