Mean reversion
Mean reversion strategies bet that an unusually large move away from a typical level is more likely to be partly undone than to continue.
Drag across the chart to read values
Measuring "stretched"
The most common yardstick is the z-score of price relative to a rolling mean:
z = (Pt − SMA(n)) / StdDev(n)A reading below −2 means price is two standard deviations under its n-day average. Bollinger Bands plot exactly these ±2 standard deviation lines around a 20-period average.
Oscillators
The Relative Strength Index (RSI), developed by J. Welles Wilder in 1978, compares average gains with average losses over a window (14 periods by default) and scales the result from 0 to 100.
RSI = 100 − 100 / (1 + average gain / average loss)Short-horizon versions (2 to 5 periods) are popular for mean reversion in equity indices: buy when the 2-period RSI drops below 10 while the long-term trend is still up, sell when it recovers above 70.
Where it works and where it fails
Broad equity indices have historically shown short-term reversal after sharp sell-offs, especially when volatility spikes. Single stocks reacting to genuinely new information, such as an earnings surprise or a fraud disclosure, often do not revert at all; that pattern is called post-earnings announcement drift.
Practice
Three quick tasks. Pick an answer to check it, or open the answer below each task.
Price is 90, the 20-day mean is 100, the standard deviation is 4. What is the z-score?
Show answer
-2.5. z = (90 - 100) / 4 = -2.5.
RSI(2) falls to 6 while the index is above its 200-day average. A short-term mean reversion rule would...
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Buy and exit on recovery. Oversold within an uptrend is the textbook mean-reversion entry.
Why do mean-reversion traders insist on stops or time limits?
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Because losses are rare but can be large. The profile is many small wins and occasional large losses.
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Further reading
Larry Connors and Cesar Alvarez, Short Term Trading Strategies That Work; Ernest Chan, Algorithmic Trading, chapters on mean reversion.