Mean Reversion
Bet that extreme price moves will revert toward an average. Most useful in range-bound or oscillating markets where prices stretch and snap back.
Thesis
Prices oscillate around a moving average or “fair value,” and extreme deviations tend to revert. Mean reversion exploits the statistical tendency of stretched conditions to snap back. It is profoundly profitable in range-bound markets and brutally dangerous in trending ones.
Entry Rules
- Wait for price to reach an extreme: 2 standard deviations from a 20-period moving average, RSI below 30 or above 70, or a measurable distance from VWAP.
- Confirm with price action — a reversal candle, a divergence on RSI or MACD.
- Enter against the extreme move, sized for the possibility that it extends further.
Exit Rules
- Take profit at the moving average (the “mean”).
- Stop loss just beyond the extreme that triggered entry.
- Time-based exit if the mean isn’t reached within a defined number of bars — extended deviation signals regime change.
When It Works
- Range-bound markets, often pre-FOMC or in low-volatility regimes.
- Pairs trading and statistical arbitrage between correlated instruments.
- Around known liquidity-driven extremes — closing prints, options expiry, end-of-quarter rebalancing.
When It Fails
- Strong trends. The trader’s adage: “the trend is your enemy in mean reversion.”
- Regime changes — during a Black Swan, the “mean” is no longer where it was yesterday.
- Markets where the mean itself is shifting quickly during a breakout.
Common Mistakes
- Adding to losers (“averaging down”) without a hard predefined risk limit.
- Mistaking a strong trend for an extreme to be faded.
- Using mean reversion in low-liquidity assets where extremes can stay extreme far longer than capital can endure.
- Ignoring broader context — overbought in an established uptrend is not the same as overbought in a range.