Mean Reversion

What is Mean Reversion?

In finance, Mean Reversion is the assumption that an asset’s price will tend to converge towards its average price over time. The implication is that if an asset’s price is far above or below its average price, it may be due for a correction.

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What you need to know:

  • Mean Reversion is the assumption that an asset’s price will tend to converge towards its average price over time.
  • The implication is that if an asset’s price is far above or below its average price, it may be due for a correction.
  • Mean Reversion is a good indicator as to when to buy or sell an asset.

The terms overbought and oversold are natural states of asset prices based on this assumption.

An overbought asset is one whose price has increased, due to excessive buying, to a high that may not be justified, and hence is likely to fall towards its average. In this case, it may be a good time to sell the asset.

Conversely, an oversold asset is one whose price has decreased, due to excessive selling, to a low that may not be justified, and hence is likely to rise towards its average. In this case, it may be a good time to buy the asset.