Decoding Mean Reversion – Strategies and Indicators

Key Takeaways 

• Mean reversion is a theory which posits that, over time, prices will move toward a long-term average.

• The mean reversion calculation gauges the extent to which an asset’s price has deviated from its longtime mean. 

• Economic events or news can disturb mean-reverting patterns, resulting in prospective losses. 

To establish a trading strategy, mean reversion is often employed as a statistical analysis of market conditions. The theory is also used in options pricing to measure the fluctuation of an asset’s volatility and long-term average.

But just what is, “mean reversion?” Here it is decoded, including strategies and indicators.

What is Mean Reversion?

In the investment space, mean reversion is a theory or concept used by traders and investors to time strategies. It suggests that, over time, prices will move toward a long-term average. 

Following that theory, then, the greater a mean is deviated from, the greater the likelihood that an asset’s price will, in the future, gravitate toward it.

Mean reversion has spawned a number of investing approaches involving buying or selling securities that, of late, have performed markedly differently from their historical averages.

Such approaches include statistical analysis, which assesses the extent to which an asset price has deviated from its “mean.” They also include volatility, risk management, and algorithmic trading strategies. More on this later.

Note that time horizon and market conditions figure prominently in mean conversion. For example, based on the time horizon, a mean reversion strategy’s effectiveness can vary. While long-term investors may utilize annual data, short-term traders may employ intraday data.

In an additional consideration, mean conversion is generally less effective in trending markets than in range-bound markets.

How Do You Calculate Mean Reversion?

The aim here is to gauge how much an asset’s price has deviated from its longtime mean. It involves a series of steps:

First, the asset’s historical price data is determined, with the time frame depending upon the time horizon. The average price is then computed over the chosen time frame.

Mean = Sum of Prices / Number of Observations

Next, each price point deviation is calculated.

Deviation = Price – Mean

Then, to understand the volatility, the price series’ standard deviation is computed.

Standard Deviation = Square Root (Sum of Squared Deviation/(Number of Obsevations – 1)

A Z-score, which measures the number of standard deviations from the mean, is next determined with these figures. 

Z – Score = Deviation /Standard Deviation

If a Z-score exceeds a specific threshold, usually 1.5 or 2, that may indicate an overvaluation. If the score is under the threshold, typically -1.5 or -2, could mean the asset is undervalued.

In an example, say a mean reversion case involves company ABC’s stock, which, over the last 200 days, has had an average closing price of 50. Then comes a favorable earnings report, which causes the price to rise to $70.

The stock price’s standard deviation over the last 2000 days is $5.

The Z-score is next calculated where (70-50)/5=4.

With a Z-score of 4, the stock is substantially overvalued, as measured against its historical “mean.” Because the stock is expected to revert to its mean, it could be a sign to short it.

Once the excitement fades over the next few weeks, the stock price ultimately falls back to about $52, which has more proximity to its historical mean.

Mean Reversion Strategies 

There are a number of trading and investing strategies that involve mean reversion, including:

• Mean reversion for forex strategy. Strategies here seek to take advantage of currency pairs reverting to their historical mean or average price. Traders frequently employ moving averages to find the mean exchange rate for a certain period. A reversion is frequently expected when a currency pair deviates substantially from the average.
• Mean reversion for intraday. These strategies involve purchasing and selling assets throughout a single day, with some traders opting to trade around a moving average. They work best with the presence of a potent trend, combined with a moving average wherein the price usually gets close then gravitates toward the trend.
• Mean reversion in pairs trading. With this approach, two correlated assets are identified. Investors and traders go short on the overvalued asset and long on the undervalued one when the price ratio between the assets deviates from its mean.

What are Arguments for Mean Reversion 

Those who come down on the side of mean reversion trading strategies point to successful track records. A number of investors including hedge fund founder Jim Simons have done very well with them.

Warren Buffet and other successful long-term investors employ a type of contrarian investing strategy that can be likened to mean reversion.

What are Arguments Against Mean Reversion?

On the other hand, some people contend that markets are efficient on their own. They believe that markets do, indeed, mirror all information available. Further, they maintain that, unless insider information or similar is provided, it is impossible to beat the markets.

Those who are against mean reversion also cite poor performance indicators. The argument is that tools similar to reversion indicators such as Shiller’s CAPE used insufficient sample sizes in testing. Therefore, their results would not work against the entire market.

What are the Benefits of Mean Reversion?

While there are challenges with mean reversion, including transaction costs and sensitivity to market conditions, there are benefits including a structured methodology for trading. This renders it easier to pinpoint entry and exit points.

Mean reversion is also versatile, in that it is applicable across various time frames and asset classes, ranging from intraday to long term.

Also, mean reversion has profit and growth prospects, particularly in range-bound markets where approaches such as trend-following may be less effective

What are the Limitations of Mean Reversion?

Challenges and limitations are part of any approach. Mean reversion limitations can include volatile market conditions. Such reversion does not work as well in robustly trending markets, where prices for extended periods may not revert to the mean.

Also, economic events or news can disturb mean-reverting patterns, resulting in prospective losses. Then there is the lack of direction. Mean reversion, unlike trend-following approaches, is non-directional. This may not work with all trading styles.

Further, shorter time frames are particularly susceptible to market rumbling, which can produce false mean-reverting signals.

Then there are the higher transaction costs associated with the frequent trading the strategy often involves.

What are Alternatives to Trading?

Traders and investors, to help time their trading and investing approaches, use mean reversion, and many have benefited. However, many are also seeking to counter the constant volatility of public markets by investing in alternatives — asset classes other than stocks and bonds. Ranging from art and real estate to venture capital and private credit, alternatives are increasingly popular due to their low correlation to public markets.

After all, over nearly the last two decades, private markets have beaten stocks in every economic downturn. While no investment is risk free, investors can potentially grow and protect their wealth by adding alternatives to their portfolio.

The leading alternative investment platform, Yieldstreet, has had some $4 billion invested on it as of 3/31/24. It offers the broadest selection of alternative asset classes available in accessible, highly vetted opportunities.

Creating a modern portfolio of varying asset types and expected performances also serves another essential purpose: diversification. Diversified holdings can potentially mitigate risk, protect against inflation, and even improve returns.

Alternative Investments and Portfolio Diversification 

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially attractive gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

As a financial theory, mean reversion posits that asset prices have a proclivity to, over time, revert to their historical mean or average. It acts as the foundation for a host of trading approaches across varying asset classes. However, investors and traders must be mindful of risks and limitations.