Definition
Mean Reversion Strategy
A mean reversion strategy assumes that prices or spreads that deviate from a historical average will tend to return to it, so it sells what has risen sharply and buys what has fallen.
Mean reversion underlies many Indian intraday and short-horizon quant strategies, from pairs trading to oscillator-based signals on liquid stocks and indices. The core bet is that extremes are temporary and that the price will snap back toward a moving average or equilibrium level.
The danger is that mean reversion fails precisely when a genuine trend or regime change occurs, turning small reverting bets into large losses, the so-called picking up pennies in front of a steamroller risk. Robust implementations combine reversion signals with stop-losses, regime filters and position limits.
Related terms
- Pairs TradingPairs trading is a market-neutral strategy that goes long one security and short a related one when their historical price relationship diverges, betting that the spread will revert to its mean.
- Statistical ArbitrageStatistical arbitrage is a class of quantitative strategies that exploit short-term, statistically predictable price relationships across many securities, holding diversified long and short positions to harvest small mispricings.
- Trend FollowingTrend following is a strategy that buys assets whose prices are rising and sells or shorts those that are falling, on the premise that established trends tend to persist for some time.
- Signal (Quantitative)A signal is a quantified indication, derived from price, fundamental or alternative data, that a security is likely to rise or fall, forming the predictive core of a systematic strategy.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.