Intermediate3 min readTrading and Investing Strategies · 2/10
The Mean-Reversion Strategy
Where trend following bets that a move will continue, mean reversion bets on the opposite: that a price which has stretched far from its average in a short time may drift back toward it. Both ideas are right at some times and wrong at others.
What you will learn
Understand mean reversion and how distance from the average is measured.
Tell a temporary dip from a drop with a real cause behind it.
You choose an average, such as the average price of the last 20 sessions, and measure how far the price is from it in percent. If the price falls well below the average in a short time and for no clear reason, someone using this strategy sees a chance it drifts back toward the average. The key word is chance, not promise.
Average 20
Furthest point 17 (−15%)
The price fell 15% below its average within a few sessions, then drifted back. That is one of two possible stories.
Same drop, two endings
An invented stockRamses Packaging (an invented company) has an average of EGP 20 and drops to 17 in a week with no news. The mean-reversion plan: enter near 17, target near the average at 19.5, and exit at a loss if it closes below 16. In the first ending the price returns to 19.8 and the plan works. In the second, two days later the company reports a sharp fall in profits and the price keeps sliding to 13. Here the exit rule at 16 is what capped the loss, instead of waiting for a rebound that no longer had a reason.
When it works and when it fails
The idea tends to look better in a stock moving in a sideways range, and in moves caused by temporary selling pressure. It fails in two cases: when the stock is in a strong downtrend, so every bounce proves temporary and the price keeps falling, and when there is a real reason for the drop, such as weak results or news that changes the company's value. In both cases the average itself moves down, so the price may never return to the level you expected.
Watch outThe most dangerous habit here is adding more each time the price falls so it "comes back faster." If the cause is real, you are enlarging the wrong position. Before entering, check the disclosures and news for a published reason. Finding none is not proof that there is none.
Find the reason before the number
If you see a stock that dropped sharply, open the disclosures and the news first and see whether there is a published reason.