what is mean reversion 
the concept of mean reversion is widely used in various financial time series data including price earnings and book value when an asset s current market price is less than its average past price it s considered attractive for purchase conversely if the current price is above the average it s expected to fall traders and investors use mean reversion for timing of their respective trading and investment strategies understanding mean reversionmean reversion is a financial theory that suggests asset prices will eventually return to their long term mean or average this concept is grounded in the belief that asset prices and historical returns will gravitate toward a long term average over time the greater the deviation from this mean the higher the probability that the asset s price will move closer to it in the future 1this theory has led to many investing strategies that involve the purchase or sale of stocks or other securities whose recent performances have differed greatly from their historical averages however a change in returns also could be a sign that a company no longer has the same prospects it once did in which case it is less likely that mean reversion would occur percentage returns and prices aren t the only measures considered in mean reverting interest rates or even the price to earnings p e ratio of a company can be subject to this phenomenon investors employ mean reversion strategies to capitalize on asset prices that have deviated significantly from their historical mean the underlying assumption is that prices eventually will revert to their long term average investors typically use mean reversion in the following ways some considerations involved in mean reversion involve time horizon and market conditions the effectiveness of a mean reversion strategy can vary based on the time horizon short term traders may use intraday data while long term investors may use yearly data another consideration is that mean reversion is more effective in range bound markets and less so in trending markets 2calculating mean reversioncalculating mean reversion involves a series of statistical and quantitative steps to measure how far an asset s price has deviated from its historical mean first historical price data is gathered for the respective asset the time frame can vary based on the investor or trader s time horizon then the average price is computed over the selected time frame m e a n s u m o f p r i c e s o f p r i c e s n u m b e r o f o b s e r v a t i o n s mean sum of prices of prices number of observations mean sumofpricesofprices numberofobservationsfrom there the deviation is calculated for each price point d e v i a t i o n p r i c e m e a n deviation price mean deviation price meannext the standard deviation of the price series is computed to understand the volatility s t a n d a r d d e v i a t i o n s q u a r e r o o t s u m o f s q u a r e d d e v i a t i o n s n u m b e r o f o b s e r v a t i o n s 1 standard deviation square root sum of squared deviations number of observations 1 standarddeviation squareroot sumofsquareddeviations numberofobservations 1 with these figures a z score is determined the z score measures how many standard deviations an element is from the mean z s c o r e d e v i a t i o n s t a n d a r d d e v i a t i o n z score deviation standard deviation z score deviation standarddeviationa z score above a certain threshold commonly 1 5 or 2 may indicate the asset is overvalued and below a certain threshold commonly 1 5 or 2 may indicate the asset is undervalued 3mean reversion and technical analysismean reversion is a prominent concept in technical analysis serving as the underlying principle for various indicators and trading strategies it helps traders identify overbought or oversold conditions thereby providing potential entry and exit points some technical indicator tools where the concept of mean reversion is involved day trading involves buying and selling financial instruments within the same trading day often holding positions for just a few minutes or hours mean reversion plays a critical role in day trading strategies as it helps traders capitalize on short term price fluctuations some key strategies include intraday moving averages day traders often use short term moving averages to identify the intraday mean price when the asset s price deviates significantly a reversion is expected 4also day traders use rsi and stochastic oscillators for identifying overbought or oversold conditions on an intraday basis signals from these technical analysis tools often prompt day traders to enter or exit positions additionally with bollinger bands day traders look for squeezes where the bands tighten indicating low volatility and the potential for a significant price move the reversion is expected to the mean or middle band 567indeed some day traders use algorithmic strategies to execute high frequency trades based on mean reversion algorithms 8swing trading is a style of trading in which positions are held for several days to weeks aiming to profit from short to medium term prices mean reversion is a key concept in swing trading helping traders identify potential reversals in price trends 