What is Mean Reversion?
Mean reversion is the theory that interest rates, security prices, or various economic indicators will, over time, return to their long-term averages after a significant short-term move.
How Does Mean Reversion Work?
Mean reversion is a strategy practiced by many quantitative hedge funds and day traders, and can be a self fulfilling prophecy. As a market begins to increase or decrease abnormally, it attracts investors and traders that decide to go against the crowd, when enough market participants have joined the contrarian side, the market moves back toward a more manageable level.
For example, let's assume that on an average day Microsoft moves $1.00 either up or down. If one day Microsoft's share price increases $7.00 and there was no significant news or announcement, than a mean revisionist would most likely believe that the stock would decrease the next day.
Why Does Mean Reversion Matter?
Mean reversion is a mathematical method of trading and investing used by many active market participants, many of which are temporarily able to move the market.