Mean Reversion Theory

Imagine a world where you know all the perfect times to buy an equity in the market. Perfect market timing is very rare but trying to time the market is very common as we see a trend of the masses trying to buy the dip or keep buying saying it will only go up when in theory it is just not true. Mean reversion theory is this thought that the respected equity will always return to the mean meaning if there is an overreaction to either deviation it will return back to the mean. Mean reversion can be a short term or long-term action but in this theory the price will trend towards the mean usually. Equities heading back towards the mean can also be directed another way as the mean is built from the firm's fundamentals which change often implying the mean changes often as well. Mean reversion theory sounds pretty obvious but implying it into one's portfolio is not that common amongst retail as many people view the markets with greed and dreams in their eyes. In theory everything should revert back to the mean well that's what this article is about, so I want to take a look at Alphabet (GOOGL). GOOGL has seen a strong swing upwards here lately and if we look at the trendline you will notice the price is above the middle Bollinger band (the mean) as well as the relative strength index (RSI) increasing also which you can see at the bottom. RSI shows you the momentum a stock is trading at such as GOOGL trading at a high momentum which could also be a sign for another mean reversion. GOOGL has a chance to revert to the mean as we can see two indicators pointing that way but if we look on the other side such as GOOGL new product and advancements we can maybe see a mean movement meaning the old mean is no longer there and a new mean is being formed. Trading off this theory is not recommended unless you know the firm inside and out but, using this theory to understand price movements is recommended and pairing it with other high percentage strategies you may be able to survive in the market. Okay so what exactly did you just read? You read a theory that lives off the idea that a stock moving radically should return back to its average price unless a fundamental change has occurred. Whilst using GOOGL as an example as they have been on a tear so I displayed them being above their mean and having a relatively high RSI basically two indicators that it may return back to its mean, but the fundamentals have changed so the efficient market wins again. Is waiting for the stock to reverse a smart idea? Possibly as short term traders will use this momentum to make a quick profit but for the long term investor who has full faith in the firm it might be smart to buy and average down if it does revert. Long term traders expect bullish moves in the future so the short term volatility shouldn't be a depending factor not unless fundamentals have changed. Options on the other hand example buying GOOGL leaps(Long term anticipation securities) can be affected way more as the underlying reverting back to the mean will lower the contract price and possibly the IV will drop also lowering your contract price. Mean reversion is fairly common so depending on what kind of position who are looking to get in to it is important that you understand this theory and the fundamentals of price movement in the underlying.