Mean reversion is a trading strategy based on the principle that prices tend to return to their average level over time. When prices stretch too far in one direction, they often snap back. Mean reversion traders profit by fading these extreme moves.
What is Mean Reversion?
Mean reversion is the tendency for prices to return to their historical average. This happens because:
- Overbought conditions attract sellers
- Oversold conditions attract buyers
- Extreme moves are often unsustainable
- Prices oscillate around a central value
Key concept: Markets spend about 70-80% of the time in trading ranges. Mean reversion strategies aim to profit during these ranging periods by buying low and selling high within the range.
Mean Reversion vs Trend Following
These are opposite approaches:
- Trend following: Buy high, sell higher (momentum)
- Mean reversion: Buy low, sell at average (fading extremes)
Many traders use both strategies, applying mean reversion in ranges and trend following in trending markets.
Identifying Mean Reversion Setups
RSI Extremes
- RSI below 30: Oversold, potential buy zone
- RSI above 70: Overbought, potential sell zone
- RSI below 20 or above 80: Extreme oversold/overbought
Bollinger Band Touches
- Price touches lower band: Potential buy signal
- Price touches upper band: Potential sell signal
- Price closing outside the bands: Extreme, likely to revert
Moving Average Distance
- Price far above the 20 EMA: Likely to pull back
- Price far below the 20 EMA: Likely to bounce
- Measure deviation using standard deviations or ATR multiples
Consecutive Candles
- 3+ consecutive red candles: Oversold, look for bounce
- 3+ consecutive green candles: Overbought, look for pullback
Entry Rules for Mean Reversion
RSI Mean Reversion Entry
- Wait for RSI to drop below 30 (oversold)
- Wait for RSI to turn back up and cross above 30
- Enter long when RSI crosses above 30
- Place stop below recent low
- Target when RSI reaches 50-60 (the mean)
RSI Mean Reversion Example
Stock drops from $50 to $44 over 5 days.
RSI falls to 22 (extremely oversold).
RSI turns up and crosses above 30 at $45.
Entry: Buy at $45.
Stop: $43 (below recent low).
Target: $48 (near 20 EMA, RSI around 50).
Bollinger Band Mean Reversion Entry
- Wait for price to touch or close outside lower band
- Wait for a bullish reversal candle
- Enter when price closes back inside the bands
- Target the middle band (20 SMA)
Consecutive Candle Strategy
- Count 3 or more consecutive red candles
- Wait for a green candle to form
- Enter at the close of the green candle or next open
- Stop below the lowest low of the red candles
- Target: Hold for 2-5 days, exit on strength
Exit Rules for Mean Reversion
Stop Loss Placement
- Below recent swing low for long trades
- Use 1.5-2x ATR below entry
- Below the Bollinger Band low
Profit Targets
- Moving average: Exit at the 20 EMA (the mean)
- Middle Bollinger Band: Natural mean reversion target
- RSI level: Exit when RSI reaches 50-60
- Fixed target: 1:1 or 1.5:1 risk-reward ratio
Time-Based Exits
Mean reversion moves happen quickly or not at all:
- Exit within 3-5 days if target is not reached
- Do not hold mean reversion trades indefinitely
- Close before earnings or major news
Complete Mean Reversion Trade
Setup: Stock falls 8% in 4 days, RSI at 25, touches lower Bollinger Band.
Entry: $46 when bullish hammer forms and RSI crosses above 30.
Stop: $44 (below hammer low, 4.3% risk).
Target: $49 (20 SMA/middle band, 6.5% reward).
Outcome: Stock bounces to $49.50 in 3 days. Exit at target.
Best Conditions for Mean Reversion
- Range-bound markets (no strong trend)
- Stocks with history of bouncing from oversold levels
- Low IV environments (no expected catalyst)
- Stocks that typically revert to their moving average
- Major support levels that have held previously
When to Avoid Mean Reversion
- Strong trends: Oversold can become more oversold
- Breakdown stocks: Avoid catching falling knives
- Before earnings: Gap risk can exceed stop loss
- During market crashes: Mean reversion fails in panics
- Stocks making new lows: No support to bounce from
Mean Reversion Filters
Use these filters to improve trade quality:
- Only trade stocks above the 200 SMA (long-term uptrend)
- Require price to be at a support level
- Need bullish divergence on RSI
- Volume spike on the reversal candle
- Market (SPY) also oversold or neutral
Mean Reversion Checklist
- Is price at an extreme level (oversold/overbought)?
- Is there a reversal signal (candle, RSI turn)?
- Is the stock not in a strong downtrend?
- Is there support below my stop level?
- Is the target (mean) reasonable to reach?
- Is risk-reward at least 1:1?
Common Mean Reversion Mistakes
- Catching falling knives without reversal confirmation
- Buying oversold in a strong downtrend
- Holding too long waiting for bigger moves
- Not using stop losses (oversold can get more oversold)
- Trading mean reversion during trending markets
- Ignoring the overall market environment
Track Your Mean Reversion Trades
Pro Trader Dashboard helps you analyze which oversold setups work best for your trading.
Summary
Mean reversion trading profits when prices snap back from extreme levels to their average. Use indicators like RSI and Bollinger Bands to identify oversold and overbought conditions, then wait for reversal confirmation before entering. Target the mean (moving average) rather than trying for big moves. The key is avoiding mean reversion in strong trends where prices can stay extreme longer than expected. Combined with proper filters and risk management, mean reversion can be a consistent strategy for range-bound markets.
Learn more: RSI indicator and Bollinger Bands.