Mean reversion is the tendency of prices to return to their average over time. When prices extend too far above or below their mean, they tend to snap back like a stretched rubber band. This statistical tendency creates reliable trading opportunities for swing traders who know how to identify and trade these setups.
Understanding Mean Reversion
The concept is simple: prices oscillate around an average value. When prices move significantly away from this average, there is a higher probability they will return toward it. This does not mean prices always revert immediately, but over time, extreme deviations tend to correct.
The core principle: What goes up too fast often comes down, and what goes down too fast often bounces. Mean reversion trading capitalizes on these corrections by entering when prices are statistically overextended.
Identifying the Mean
The first step in mean reversion trading is defining what "mean" you are measuring against:
Moving Averages
The most common mean is a moving average. Popular choices include:
- 20-day MA: Short-term mean, faster reversion signals
- 50-day MA: Medium-term mean, balanced approach
- 200-day MA: Long-term mean, major extension signals
VWAP
Volume Weighted Average Price is the mean price weighted by volume. Prices often revert to VWAP, making it excellent for intraday mean reversion.
Bollinger Band Midline
The middle band (typically 20-period SMA) serves as a mean, with the bands showing standard deviation extensions.
Measuring Extension from Mean
Stock ABC with 50-day moving average at $100:
- Current price: $115 (15% above MA)
- Historical data: Stock rarely extends more than 12% above MA
- Signal: Overextended, watching for reversion setup
- Target: Return to $100-$105 area
Indicators for Mean Reversion
Several indicators help identify when prices are ready to revert:
RSI (Relative Strength Index)
RSI above 70 suggests overbought conditions; below 30 suggests oversold. For mean reversion, these extremes signal potential reversal points.
Bollinger Bands
When price closes outside the bands, it indicates a statistical extreme. About 95% of price action stays within 2 standard deviation bands.
Standard Deviation Distance
Measuring how many standard deviations price is from the mean helps quantify the extension. Moves beyond 2 standard deviations are statistically rare and often revert.
Percent From Moving Average
Tracking the percentage distance from key moving averages shows when prices are historically overextended.
Multiple signals: The best mean reversion setups combine multiple indicators. RSI extreme plus Bollinger Band touch plus large MA deviation creates a higher probability setup.
Mean Reversion Swing Trade Setup
A systematic approach to mean reversion swing trades:
- Identify extension: Price is significantly above or below the mean
- Confirm with indicators: RSI extreme, outside Bollinger Bands
- Wait for reversal signal: Candlestick pattern, momentum shift
- Enter on confirmation: Do not catch falling knives or short rockets
- Set stop beyond extreme: Protect against continued extension
- Target the mean: Take profits as price approaches the moving average
Oversold Bounce Setup
Stock XYZ drops sharply from $80 to $65 in one week:
- Extension: Price 15% below 20-day MA, largest in 2 years
- RSI: Dropped to 22, extremely oversold
- Bollinger Bands: Closed below lower band 3 days in row
- Reversal signal: Hammer candle on increased volume
- Entry: Buy at $66 on break of hammer high
- Stop: $63 below the hammer low
- Target: $74 near the 20-day MA
Types of Mean Reversion Setups
Different market conditions produce different mean reversion opportunities:
Oversold Bounce
Buy stocks that have dropped excessively below their mean. Look for quality stocks with temporary weakness, not broken companies.
Overbought Fade
Short stocks that have rallied excessively above their mean. This is riskier as strong stocks can stay overbought longer.
Gap Fill Trades
Gaps often fill, representing a form of mean reversion. Trade toward the gap fill area.
Range Reversals
In range-bound markets, trade reversals at range extremes back toward the middle.
Filtering for Quality Setups
Not all mean reversion setups are worth trading:
Prefer Relative Strength Stocks
For oversold bounces, choose stocks with good long-term trends that have pulled back. These are more likely to bounce than weak stocks getting weaker.
Avoid Structural Breaks
If a stock breaks major support or gaps down on bad earnings, mean reversion is less reliable. Fundamental deterioration can prevent reversion.
Consider Sector Context
A stock pulling back while its sector is strong has better mean reversion potential than one falling with a weak sector.
Check the Catalyst
News-driven moves that do not change fundamentals are better mean reversion candidates than moves from genuine fundamental changes.
Analyze Your Mean Reversion Trades
Pro Trader Dashboard tracks your reversion trades and shows which indicator combinations work best for your style.
Risk Management for Mean Reversion
Mean reversion carries specific risks that require careful management:
- Extended extensions: Prices can stay overbought/oversold longer than expected
- Trend changes: What looks like extension might be the start of a new trend
- Stop placement: Stops must be beyond the extreme, which can be far away
Position Sizing
Because stops can be wide in mean reversion trades, position sizes must be calculated carefully:
- Risk a fixed percentage of account (1-2%)
- Calculate position size based on stop distance
- Scale in if the extension continues
Combining Mean Reversion with Trend
The highest probability mean reversion trades align with the larger trend:
- In uptrends: Buy oversold conditions; avoid shorting overbought
- In downtrends: Short overbought rallies; avoid buying oversold
- In ranges: Trade both directions at extremes
Timeframes for Mean Reversion
The strategy adapts to different timeframes:
- Intraday: VWAP reversion, opening range extremes
- Daily: 5-10 day swings, RSI extremes
- Weekly: Multi-week swings from monthly extremes
Common Mean Reversion Mistakes
Avoid these errors that turn winning strategies into losses:
- Catching falling knives: Entering before reversal confirmation
- Fighting strong trends: Fading moves that become new trends
- No stop loss: Hoping extended positions will revert
- Targeting full reversion: Taking partial profits before the mean
- Ignoring fundamentals: Trading broken stocks expecting bounces
- Oversizing: Getting too big because "it has to bounce"
Building a Mean Reversion System
Create rules-based trading for consistency:
- Define your mean (which moving average or indicator)
- Set extension thresholds (how far is too far)
- Specify entry triggers (what confirms reversal)
- Determine stop placement (beyond the extreme)
- Set profit targets (partial at midway, full at mean)
- Backtest and refine the rules
Summary
Mean reversion swing trading capitalizes on the tendency of prices to return to their average after extreme moves. Identify extensions using moving averages, RSI, and Bollinger Bands. Wait for confirmation of reversal before entering, as prices can stay extended longer than expected. Target returns to the mean, manage risk with properly placed stops, and avoid fighting strong trends. The best mean reversion setups combine multiple indicators in stocks with strong long-term fundamentals experiencing temporary weakness.