Mean reversion is the idea that the price of an asset will eventually move back towards its average or “mean” value over time. This concept is based on the idea that prices tend to fluctuate around a central or average value, and that deviations from this value are usually temporary.
In financial markets, mean reversion is often used to describe the tendency of an asset’s price to move back towards its long-term average price after experiencing significant price movements. For example, if a stock has had a sustained period of price appreciation, it may be considered overvalued and likely to experience mean reversion as the price eventually falls back towards its long-term average. On the other hand, if a stock has experienced a prolonged period of price decline, it may be considered undervalued and likely to experience mean reversion as the price eventually rises back towards its long-term average.
Mean reversion can be used as a trading strategy by buying an asset that is undervalued or selling an asset that is overvalued, with the expectation that the price will eventually revert back towards its long-term average. This strategy can be based on technical analysis, which uses past price and volume data to identify trends and patterns, or on fundamental analysis, which looks at a company’s financial health and industry trends to determine the intrinsic value of its stock.
Overall, mean reversion is a useful concept for traders and investors to understand, as it can provide insight into the likely direction of an asset’s price and inform trading decisions.