Mean reversion is a financial theory suggesting that asset prices and historical returns eventually return to their long-term mean or average level. Traders who use this strategy operate on the assumption that extreme price movements are temporary and will correct back toward a statistical average over time.
To identify potential mean reversion opportunities, traders often use technical indicators such as Bollinger Bands, the Relative Strength Index (RSI), or moving averages. For example, a trader might look for an asset price that has moved two standard deviations away from its 20-day simple moving average. If the RSI drops below 30, the asset is considered oversold, signaling a potential upward correction toward the mean. Conversely, an RSI above 70 suggests the asset is overbought and may face a downward correction.
This strategy relies on the belief that markets are cyclical rather than linear. However, mean reversion is not a predictive tool for guaranteed profits. Prices can remain at extreme levels for extended periods, or a fundamental shift in the asset may establish a new, permanent price range. All trading involves significant risk, and historical price behavior does not ensure future results. Proper risk management, such as using stop-loss orders, is essential when executing mean reversion trades.
How this answer was produced
AI-assisted draft, human-reviewed by AlphaScala editorial against our standards before publication. General education, not advice for your specific situation.