What is Mean Reversion in Trading?
Quick Answer: Mean reversion assumes price will return to its average after deviations, using statistical tools to fade overextended moves.
Understanding Mean Reversion
Mean reversion strategies assume price will eventually return to an average value after deviating. Traders measure that “mean” using moving averages, VWAP, or statistical bands and then fade extremes with the expectation of reversion.
Core Elements
- Identify the mean: Choose a reference—20-period EMA, VWAP, or statistical tools like Bollinger Bands.
- Define extremes: Use z-scores, RSI, or standard deviation multiples to flag overbought/oversold conditions.
- Trigger entries: Wait for rejection candles, divergence, or lower-time-frame confirmation before fading the move.
- Plan exits: Target the mean or opposing band; scale out as price normalizes.
Market Selection
Mean reversion thrives in ranging markets, session lulls, or pairs anchored by carry trades. Avoid deploying it during strong trends or high-impact news.
Risk Controls
Extended trends can stay overbought for weeks. Combine mean reversion with higher-time-frame filters, volatility regimes, and hard stops. Size positions modestly and consider time stops if price fails to revert.
No Martingales
Doubling into losers under the guise of mean reversion leads to blow-ups. Respect invalidation levels and reset when evidence changes.
Related Terms
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