Definition
Mean reversion posits that extreme price deviations are temporary—prices eventually return toward long-term averages. This drives contrarian strategies: buy after large declines, sell after large rallies. Mean reversion is strongest in interest rates and volatility, moderate in equity valuations, and weakest in commodity prices. The challenge is distinguishing temporary deviations from permanent regime changes.
lightbulb Example
The VIX (volatility index) spikes to 40 during a market panic—its long-term average is 18. A mean-reversion strategy sells volatility (via VIX puts or short VIX futures), profiting as volatility normalizes over subsequent weeks.
verified_user Key Points
- Prices tend to revert to long-term averages
- Strongest in volatility and interest rates
- Foundation of contrarian and value investing
- Challenge: distinguishing mean reversion from regime change