What are Mean Reversion Strategies?

 

Welcome to Vrd Nation. Through this channel, we are trying to educate our fellow investors and traders on every topic that pertains to investing in trading, using real life examples, case studies, and real-life trades using animations. We’re trying everything that we can to make things simple. So, if you’re here for the first time and you’re hearing me for the first time, do not forget to subscribe.

In today’s session, we will learn a very important concept called Mean reversion. Firstly, breaking this phrase down, mean refers to average and reversion means going back and so mean reversion refers to the phenomenon of stocks or indices returning back to their averages if they have moved far away from them.

That is the definition of mean reversion, but let us understand mean reversion from a practical standpoint. Let me give you an example of that. Assume on an average, it takes you about one hour to go from your home to the office. Now, depending on the traffic conditions, sometimes it can even take longer like one and a half hours, or sometimes you can reach in a very short period of time, say half an hour, but the average which is also the mean and the most likely duration would be somewhere around one hour. Imagine that one day you got stuck in a bad traffic jam as something unusual happened such as an accident or something that it took you about two hours to reach. Now does that mean that from that day onwards, we will plan for two hours of commute from your home to your office?

No, because you know that exceptions happen and we cannot plan for these things and eventually life will go back to normal. In the same way stocks tend to trade around their mean valuation, but every once in a while, due to some news flow or some market intervention, they keep moving away from the mean. In case of a positive news flow, the stock can jump very quickly and can go up 10% to 20%. Similarly, in case of a negative news, the stock can come down 20% to 30%, but similar to those extreme traffic conditions, these moves turn out to be temporary and the stock eventually returns back to the mean and hence the term mean reversion. Hence, a mean reversion strategy relies on a stock or index to go back to normal.

If a stock has gone down, people will expect it to revert back to the mean which means that we expect it to go back up and so they will take a long position. Similarly, if the stock has gone up a lot, then mean reversion traders will take short positions because they expect the stock to come down towards the mean.

Let me take a real-life example to explain this. The concept of mean reversion can be applied on different timeframes. It can be applied on a daily timeframe, weekly timeframe, and as well as on intraday. I like to apply this concept more on an intraday basis because, practically speaking, if a stock on an index has to move significantly, there has to be a big trigger. Something has to move the market on a day-to-day basis. Most of the time you don’t have that kind of a trigger. Nothing is going to happen overnight that is going to substantially change the fundamentals of the companies. So, traders like me look for opportunities to take mean reversion kinds of trades on an intraday basis.

I’m going to take an example of last Thursday and I discussed these trades recently on another video and you might want to watch that. But let’s take a look. This is last Thursday and so this is essentially where the market closed yesterday. Let us see what happened throughout the day. The market gapped down and for the first half, the market went closer to the mean. It went away from the mean and then again, like a pendulum, it swung back to the mean again and the mean essentially becomes the equilibrium point of the market and any time there is a big difference between the current market price and the mean, there is a potential trading opportunity for the market to move.

What I did was in the first half, I took long trades, where the market was far below the averages and the market gravitated towards the mean. In the second half, I took short trades, but based on the mean.

This is how mean reversion traders think, but you have to understand that mean reversion is one phenomenon and does not mean that the market will always revert to the mean. There are circumstances when the market can become trending and that is where your judgment counts. Your experience and your knowledge as a trader will come into picture, because on a trending day, if you try to apply, you can get in trouble.

I hope that this video would have given you a decent perspective of what mean reversion is as a phenomenon and how professional traders apply that in real life.

Welcome to Vrd Nation. Through this channel, we are trying to educate our fellow investors and traders on every topic that pertains to investing in trading, using real life examples, case studies, and real-life trades using animations. We’re trying everything that we can to make things simple. So, if you’re here for the first time and you’re hearing me for the first time, do not forget to subscribe.

In today’s session, we will learn a very important concept called Mean reversion. Firstly, breaking this phrase down, mean refers to average and reversion means going back and so mean reversion refers to the phenomenon of stocks or indices returning back to their averages if they have moved far away from them.

That is the definition of mean reversion, but let us understand mean reversion from a practical standpoint. Let me give you an example of that. Assume on an average, it takes you about one hour to go from your home to the office. Now, depending on the traffic conditions, sometimes it can even take longer like one and a half hours, or sometimes you can reach in a very short period of time, say half an hour, but the average which is also the mean and the most likely duration would be somewhere around one hour. Imagine that one day you got stuck in a bad traffic jam as something unusual happened such as an accident or something that it took you about two hours to reach. Now does that mean that from that day onwards, we will plan for two hours of commute from your home to your office?

No, because you know that exceptions happen and we cannot plan for these things and eventually life will go back to normal. In the same way stocks tend to trade around their mean valuation, but every once in a while, due to some news flow or some market intervention, they keep moving away from the mean. In case of a positive news flow, the stock can jump very quickly and can go up 10% to 20%. Similarly, in case of a negative news, the stock can come down 20% to 30%, but similar to those extreme traffic conditions, these moves turn out to be temporary and the stock eventually returns back to the mean and hence the term mean reversion. Hence, a mean reversion strategy relies on a stock or index to go back to normal.

If a stock has gone down, people will expect it to revert back to the mean which means that we expect it to go back up and so they will take a long position. Similarly, if the stock has gone up a lot, then mean reversion traders will take short positions because they expect the stock to come down towards the mean.

Let me take a real-life example to explain this. The concept of mean reversion can be applied on different timeframes. It can be applied on a daily timeframe, weekly timeframe, and as well as on intraday. I like to apply this concept more on an intraday basis because, practically speaking, if a stock on an index has to move significantly, there has to be a big trigger. Something has to move the market on a day-to-day basis. Most of the time you don’t have that kind of a trigger. Nothing is going to happen overnight that is going to substantially change the fundamentals of the companies. So, traders like me look for opportunities to take mean reversion kinds of trades on an intraday basis.

I’m going to take an example of last Thursday and I discussed these trades recently on another video and you might want to watch that. But let’s take a look. This is last Thursday and so this is essentially where the market closed yesterday. Let us see what happened throughout the day. The market gapped down and for the first half, the market went closer to the mean. It went away from the mean and then again, like a pendulum, it swung back to the mean again and the mean essentially becomes the equilibrium point of the market and any time there is a big difference between the current market price and the mean, there is a potential trading opportunity for the market to move.

What I did was in the first half, I took long trades, where the market was far below the averages and the market gravitated towards the mean. In the second half, I took short trades, but based on the mean.

This is how mean reversion traders think, but you have to understand that mean reversion is one phenomenon and does not mean that the market will always revert to the mean. There are circumstances when the market can become trending and that is where your judgment counts. Your experience and your knowledge as a trader will come into picture, because on a trending day, if you try to apply, you can get in trouble.

I hope that this video would have given you a decent perspective of what mean reversion is as a phenomenon and how professional traders apply that in real life.