Using Mean Reversion to Predict The Stock Market

While the market in itself cannot be accurately predicted, there are indeed pointers that guide the investor and these pointers are garnered based on historical data, demand and supply, the market itself and so on.

Let’s start by understanding that the stock market cannot exactly be predicted; not unless you have a genie with magic you can bet your money on.

While the market in itself cannot be accurately predicted, there are indeed pointers that guide the investor and these pointers are garnered based on historical data, demand and supply, the market itself and so on.

In our last set of articles, we reviewed how a company’s historical financial statements can be used to create ratios that you can compare with industry averages as well as benchmarks. Another way historical data can be used as a basis for investment decisions is with the use of Mean Reversion.

What is Mean Reversion?

Mean Reversion is a tool that believes that over a long period of time, variables like the stock price will average out.

Just the same way theories are created based on observation of individuals of a society for a long period of time, the idea behind mean reversion is that experienced investors who have watched the market for decades going up and down believe the market will attain a point of balance.

What this means is that if you take the historical data of a company for a long time and calculate the mean or average of the entire dataset, you will get the true image of the company.

This, of course, isn’t limited to stock prices; this tool is also used for calculating the Gross Domestic Product of an economy, exchange rates, interest rates, and so on.

How To Use It In The Stock Market

The mean reversion theory is used in the creation of various strategies and can be used in a broad trading strategy. In choosing stocks, the theory can be used to see situations where abnormal activities have occurred.

If a certain trend has been determined and something extraneous is discovered, investors will simply hope for when it will return to its normal trend. For traders who want to make gains from price movements, this poses an opportunity.

For example, if a company has had a long trend of high stock prices and an abnormal activity occurs that crashes the stock price, stock traders will purchase those shares with the aim of selling high and making a profit.

Mean reversion, therefore, attempts to capitalize on extreme changes with the assumption that it will return to its original value. It is also used in options pricing.

While mean reversion is a great idea when trying to understand the historical records of a company to determine whether its average value is worth the investment decision or not, it presents no guarantees when it comes to trading for profit.

This is essentially because there is no guarantee that a trend returns to its normal pattern. It is, thus, best suited as a guide and not a tool for prediction.

Written by Lawretta Egba