A mean reversion trading strategy helps you identify stocks that are vastly over- or under-priced. This can lead to incredible profit opportunities. Here’s a non-financial example of how it works:
Being a Terrible Bowler Taught Me How to Pick Stocks.
One of my favorite activities to do with my wife and four kids is bowling. I like it purely for the quality family time it gives us, not because I’m any good. My average score is about 85.
Yep…you read that correctly…85. A trained monkey could out-bowl me.
But a few years ago, after what can only be described as a disturbance in the space-time continuum, I bowled over 150 on three straight outings.
I didn’t do anything different. I still used a lane ball. I didn’t watch any how-to videos or take lessons. I didn’t even practice. Yet, three games in a row, I almost doubled my average score.
Now let me ask you, which is more likely?
- I suddenly became a great bowler who would continue to score over 150 each game. Or…
- This was an anomaly, and I would soon return to my average score.
If you chose #2, you are correct. After those three games, I returned to my trusty average of 85. I don’t even think I’ve broken 100 since then.
That’s mean reversion.
In finance, mean reversion is the theory that after experiencing volatility, an asset’s price will return (revert) to its long-term average level (mean).
With mean reversion trading, you look for stocks that are either selling far above or far below their average for no discernible reason. When this happens, it’s highly likely that the stock price will revert to its mean.
That is your opportunity to profit.
Stocks will often produce signals when they’re about to return to their average price range. You can spot these through price swings (up or down) and/or different technical indicators. The latter can reveal if a stock is overbought/sold (e.g. RSI), if it’s trading at a price extreme (e.g. Bollinger Bands), if its directional momentum is weakening (e.g. ADX), and more.
Unfortunately, no single technical indicator can predict a mean reversion. You have to assess a number of variables with the stock itself and the overall market. Even then, you will not be correct 100% of the time. You can, however, find trades that have a high probability of success.
That idea is at the core of my trading strategy: find opportunities when the odds are in your favor, and pounce. You won’t win every time, but you will come out ahead in the long run.
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