Glossary
Mean reversion
The tendency of a price or ratio to move back toward its long-run average after an unusual move away from it.
Mean reversion is the idea that a price, spread or ratio that has moved unusually far from its average will tend to drift back toward it. It is the opposite bet to momentum. Mean-reversion strategies buy what has fallen sharply and sell what has risen sharply, expecting the extreme to fade. The concept also appears in valuation, where ratios such as price-to-earnings or profit margins are often assumed to return toward long-run norms.
How a reversion signal is measured
Traders usually express "how far from normal" as a z-score: the distance from a moving average in units of standard deviation.
Where it works and where it fails
Reversion tends to show up over short horizons, such as days, in liquid stocks and in spreads between closely related assets, the basis of pairs trading. Oscillators like the RSI are popular tools for it because they flag overbought and oversold conditions.
The danger is that the average itself moves. A stock that falls because the business has changed, after a fraud, a lost contract or a broken thesis, may never revisit the old mean, and a strategy that keeps buying the dip compounds losses. Mean reversion also struggles in strong trends, when "overbought" can stay overbought for weeks. Stop rules and position limits are part of any serious test of the idea.