Mean reversion trading strategy




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Mean reversion trading strategyOther People Are Reading

Calculation

The mean reversion strategy may apply to a single asset, or multiple assets, and it assumes that the asset's average price follows a long-term trend. If a stock's average price was $60 two years ago, $61 last year and $62 this year, then an investor using the mean reversion strategy would buy the stock if the price dipped to $58, because he expects it to reach $63 during the next year.

Major Events

A disaster or windfall can break the trend, causing a loss for an investor who uses the mean reversion trading strategy. If a car company restates its earnings, declares bankruptcy or spends a large amount of money to make cars that customers don't want to buy, the price of the car company's stock may drop and remain low, reflecting the company's reduced value.

Pair Trading

With pair trading, an investor uses the normal relationship between the prices of two assets in a mean reversion strategy. For example, one oil company's stock has a price of $40 a share, and a second oil company's stock trades for $50. A discovery of a new oil well or an alternative fuel source affects both oil companies, so their share prices have some correlation with each other. If the price of the first oil company's stock rises by 10 percent to $44 and the share price of the second company remains $50, a pair trading strategy implies that the investor should purchase the second company's stock, in case it also increases by 10 percent to $55.

Time Frame

The time delay before the price of an asset returns to the mean depends on the type of asset. If the value of a house drops from $400,000 to $150,000, and the long-term trend suggests that the value will return to $280,000, it may take a decade for the housing market to recover. An investor should estimate the average amount of time that the price of the asset usually differs from the mean before it returns to it.

Reversion to the mean does not guarantee that the investor will receive a profit. If the investor expects a stock's price to return to $50 tomorrow, but its value is $40 today and it returns to $50 next week instead, the stock has returned to the mean. If the investor holds an option to buy the stock at $45 that expires today, it's worthless.

Mean Reversion Trading Strategy

Mean reversion is a mathematical system that is also applied for stock trading and investing. The theory behind it is that a stock's high and low prices are only temporary, and that a security's price will tend to revert towards an average price over time. So stocks that dip down are likely to bounce back up.

When the stock is trading at less than the average price, the security is considered attractive for entering a 'buy trade', the expectation being of course that the price will rise. When the present market price is above the stock's average price, the stock's tendency is to fall and revert back to the mean. So in a nutshell, deviations from the average stock price are expected to revert back to the average all other things being equal.

When using the reversion trading strategy to trade it is very important to be careful as large dips may imply a change of fundamental factors which may not revert back to a 'mean'.

Mean Reversion Trading Strategy

As you gain more experience as a binary options trader, you’ll look to integrate a range of options trading strategies to improve your results. Developing your experience as a binary options trader takes time and practice but you can always look to integrate some techniques and strategies to help you along the way.

The mean reversion strategy is one of these strategies and suggests that the prices of underlying assets retract back towards a mean – or average. In traditional trading, the average can be the asset’s historical average of the price or the historical return.

To use this as one of your binary options trading strategies, you need to identify an asset’s average and then determine if the asset price is likely to settle back at this value within a given period of time. Many of us in the trading community visualize this by picturing a rubber band, where the value fluctuates up and down and a trader identifies how far the value will stretch before it snaps back to the average.

The mean reversion strategy has been used in traditional trading for quite some time. The idea behind it is heavily linked to the view that market performance moves in cycles and that history often repeats itself. So, after you perform research on your chosen asset, you need to understand what the “norm” is for that particular asset in order to determine what the mean value would be for the asset.

From a binary options trading perspective, the mean reversion strategy would heavily apply to stocks and indices. Since the performance of both ebbs and flows with movements in the wider economy, the value would often revert back to the mean over time. Since the objective of executing a binary options trade is to make a price on the direction in value versus the actual value, it is important for binary traders to do their research on understand what the mean of the asset.

For instance, let’s say that after conducting research you have identified that the mean value of the Dow Jones Industrial Average is 14,222.00 over the past year. If the value of the Dow is trading at 15,000.00 you can take your knowledge gained from the mean reversion strategy and may decide to place a put option on the value of the Dow.

Using advanced techniques, such as the mean reversion strategy, can help binary options traders place their trades. This teamed with other techniques, such as technical and fundamental analysis, can lead to greater overall returns in the short and long-term.