Mean reversion

The rubber band

Stretch a rubber band and let go. It snaps back to its normal shape. Mean reversion is the idea that prices often do the same: when they stretch far from their average, they tend to come back toward it. ("Mean" is a math word for average.)

Or think of a dog on a long leash. It runs ahead, sniffs around, but always ends up back near its owner. The owner is the average price.

This is the opposite of trend following. A trend follower joins a big move. A mean reversion trader fades it, betting that the stretch won't last.

How traders measure "too far"

You met these tools in Level 4:

• Bollinger Bands: a middle line (the 20-period average) with a band above and below. A close outside a band means price is stretched.
• RSI: below 30 is often called stretched down, above 70 stretched up.
• VWAP: day traders watch how far price runs from it.

An example rule set

Made up, just to see the shape:

1. Market type: only when price is going sideways. A simple check: the 50-period moving average is flat, not climbing or falling.
2. Stretch: wait for a candle to close below the lower Bollinger Band.
3. Entry: when the next candle closes back inside the band.
4. Stop: just under the low of the stretched candle.
5. Target: the middle line, the average.

Say the average is $100. Price stretches down and closes at $94, then the next candle closes back inside at $95. You get in at $95 with a stop at $93, risking $2. The target is the average, $100, which is $5 away.

When it works

In calm, sideways markets where price keeps bouncing between a floor and a ceiling. Mean reversion often wins more trades than it loses, but the wins are usually small.

When it fails

Sometimes the rubber band doesn't snap back. It breaks.

• In a strong trend, price can hug the lower band for days and keep falling. Each "stretched" signal is another losing trade.
• Big news can change what a stock is worth. Then the old average doesn't matter anymore.
• Without a stop, one of these can wipe out many small wins. That's why the stop is not optional.

Notice the pattern: trend following struggles in sideways markets, and mean reversion struggles in trends. Some traders use both, but only in the market type each one fits.

Before trusting any of this, test it on old charts. Level 8 shows how.

Remember

• Mean reversion bets that a stretched price comes back to its average.
• It works best in sideways markets and worst in strong trends.
• It often wins often but small, so one big loss can hurt a lot.
• The stop is what keeps a broken rubber band from breaking you.