Mean Reversion

Mean Reversion theory suggests that considerable deviations in security prices tend to return to their historical mean. In other words, if the price moves too far away from its long term average, it will revert back to its average. This theory considers only the extreme changes and does not include the normal growth and other market events that take place.

When the current market price is less than the average price, traders purchase the stock with an expectation that the price will rise. Similarly, When the price is above the average price, investors will sell that security. Pairs trading strategy is based on the mean reversion theory.

Example

Let us assume that the 1 year average price of Stock ABC is $125 and the stock is trading at $150. There may be a gradual increase in the price of the stock over the year due to strong fundamentals but if the stock price increases by 8% within a trading day to $162, then one might short the stock assuming it will return to its long term mean and book a profit.