Mean reversion is one of the oldest and most intuitive trading concepts. When prices stretch too far in one direction, they tend to snap back. Mean reversion traders profit by identifying these extremes and positioning for the return to normalcy. This guide will show you how to build and implement effective mean reversion strategies.
What is Mean Reversion?
Mean reversion is the theory that prices and returns eventually move back toward their historical average or mean. When a stock falls significantly below its average, it tends to rise. When it rises significantly above its average, it tends to fall.
The simple version: What goes up must come down, and what goes down often comes back up. Mean reversion traders buy when prices have fallen too far and sell when prices have risen too much, betting on a return to normal.
Why Mean Reversion Works
Market Psychology
Markets tend to overreact to both good and bad news. Fear pushes prices too low, greed pushes them too high. Mean reversion capitalizes on these emotional extremes.
Fundamental Anchoring
Stocks have underlying fundamental values. When prices deviate significantly from fundamentals, value investors step in to correct the mispricing.
Statistical Reality
Many financial time series exhibit stationary properties over certain time frames. This means they fluctuate around a stable average rather than trending indefinitely.
Key Mean Reversion Indicators
Bollinger Bands
Bollinger Bands plot two standard deviations above and below a moving average. When price touches the lower band, it is considered oversold. When it touches the upper band, it is overbought.
Bollinger Band Strategy
- Calculate 20-day moving average
- Add/subtract 2 standard deviations for bands
- Buy when price closes below lower band
- Sell when price returns to middle band
- Stop-loss: 1 ATR below entry
RSI (Relative Strength Index)
RSI measures the speed and magnitude of price changes on a scale of 0-100. Readings below 30 indicate oversold conditions, while readings above 70 indicate overbought conditions.
Moving Average Distance
Measuring how far price has deviated from a moving average can identify extremes. A 10% deviation from the 50-day moving average might signal a mean reversion opportunity.
Z-Score
The z-score measures how many standard deviations the current price is from its mean. A z-score of -2 means the price is 2 standard deviations below average, suggesting potential upside.
Mean Reversion Entry Strategies
RSI Oversold/Overbought
- Buy signal: RSI drops below 30 and then crosses back above
- Sell signal: RSI rises above 70 and then crosses back below
- Confirmation: Wait for the RSI to reverse direction, not just hit the level
Bollinger Band Touch
- Buy signal: Price closes below lower band, then closes back inside
- Sell signal: Price closes above upper band, then closes back inside
- Enhancement: Combine with RSI for stronger signals
Consecutive Down Days
A simple but effective approach:
- Buy after 3-5 consecutive down days
- Sell after the first up day or after X days
- This works best in overall uptrending markets
Combined Entry Example
Stock XYZ setup:
- Price touches lower Bollinger Band
- RSI reads 25 (oversold)
- Stock has fallen 4 days in a row
- Price is 8% below 50-day MA
Multiple confirmations suggest a high-probability mean reversion entry. Buy with a target at the 50-day MA and stop 2% below entry.
Exit Strategies
Profit Targets
- Moving average: Exit when price returns to 20 or 50-day MA
- Bollinger middle band: Exit when price reaches the middle band
- Fixed percentage: Take profits at 3-5% gain
- Opposite extreme: Exit when RSI reaches overbought (if you bought oversold)
Stop-Losses
- ATR-based: 1.5-2x ATR below entry
- Percentage: 2-5% below entry price
- Time stop: Exit if trade has not worked in 5-10 days
Trailing Stops
Once in profit, use trailing stops to protect gains while allowing for continued mean reversion:
- Trail 1 ATR below the highest close since entry
- Trail using a shorter-period moving average
Market Conditions Matter
Best Conditions for Mean Reversion
- Range-bound markets: When the overall market is trading sideways
- Low volatility: Extremes are more likely to revert in calm markets
- Strong underlying fundamentals: Quality stocks revert more reliably
- No pending catalysts: Avoid mean reversion ahead of earnings or major news
Conditions to Avoid
- Strong trends: Mean reversion fails in trending markets (catches falling knives)
- High volatility: Extremes can become more extreme
- Breaking news: Fundamental changes can invalidate historical patterns
- Sector rotation: Entire sectors can stay depressed or elevated
Risk Management
Position Sizing
Mean reversion trades can go against you before working. Conservative sizing is essential:
- Risk no more than 1-2% of capital per trade
- Scale in if you have conviction (add at lower levels)
- Keep total portfolio exposure to mean reversion strategies limited
Diversification
- Trade multiple stocks to avoid single-stock risk
- Spread entries across different sectors
- Use different timeframes for different positions
The Falling Knife Problem
The biggest risk in mean reversion is buying something that continues to fall. Protect yourself by:
- Requiring confirmation (waiting for first uptick)
- Using strict stop-losses
- Avoiding stocks with deteriorating fundamentals
- Checking for news that might explain the decline
Risk Management Example
Account size: $100,000
Maximum risk per trade: 1% ($1,000)
Stock price: $50, Stop-loss at $48 (4% loss)
Position size: $1,000 / $2 risk = 500 shares = $25,000
If stopped out, you lose $1,000 (1% of account)
Backtesting Mean Reversion Strategies
Before trading live, backtest your strategy thoroughly:
Key Metrics to Track
- Win rate (typically 55-65% for good mean reversion strategies)
- Average win vs. average loss
- Maximum drawdown
- Sharpe ratio
- Number of trades (ensure statistical significance)
Backtesting Pitfalls
- Overfitting: Do not optimize too many parameters
- Survivorship bias: Include delisted stocks
- Transaction costs: Include realistic slippage and commissions
- Look-ahead bias: Only use information available at the time
Mean Reversion in Different Timeframes
Intraday
Mean reversion works well intraday, with stocks often reverting to VWAP or opening range levels. Requires fast execution and tight risk management.
Swing Trading (2-10 days)
The sweet spot for mean reversion. RSI and Bollinger Band strategies work well here. Gives time for reversion without extended exposure.
Position Trading (weeks to months)
Longer-term mean reversion focuses on valuations and sector rotations. Requires more patience and conviction.
Track Your Mean Reversion Trades
Pro Trader Dashboard helps you analyze your mean reversion strategies. See which setups work best, track your win rate, and optimize your entries and exits.
Summary
Mean reversion trading capitalizes on the tendency of prices to return to their average after extreme moves. Using indicators like RSI, Bollinger Bands, and z-scores, traders can identify high-probability entry points. Success requires proper risk management, understanding of market conditions, and the discipline to wait for genuine extremes rather than minor fluctuations.
Explore complementary strategies in our guides on trend following (the opposite approach) or learn about pairs trading.