Mean Reversion - A theory I believe every investor should understand

In trading terms, mean reversion is the theory that asset prices tend to move back toward their long-term average or mean over time. The theory is based on the belief that extreme highs or lows in prices or other metrics will not persist and that they will eventually revert back to an average level.

I have used this concept successfully in the markets for over eight years, particularly in currency markets, by identifying currency crosses that are trading in over-extended conditions. Everyone knows the saying 'buy low and sell high', but very few actually implement this when it comes to trading.

This is essential knowledge for any investor to understand, whether it's cryptocurrency, the stock market or used car prices, having a basic understanding of how to determine whether an asset is cheap or expensive is indispensable. 

Let's take Bitcoin as an example. In March 2024 it was trading at upwards of $70,000. It was gaining traction in the mainstream media and I even had my Mum ask me what it was and how to buy it.... This is an immediate red flag! Why? Because the price is over-extended from the mean. 

How do we identify this using the chart below? We add a 50-period moving average to our chart and determine whether we are creating a great distance between that and the current price. In this case, we were - it was heavily over-extended. So if we are buying here, like much of the retail trading world did, we are buying it at a very high price. 

Now, you may not be a day trader so shorting Bitcoin here isn't something you were looking to do, but at the very least, understanding the concept of mean reversion would have stopped you from buying it at a premium.

So when should we buy? The simple answer is 'when it's cheap', and we identify this by waiting for the price to over-extend below the mean. Instead of being $16,000+ offside on a buy position, we could wait for the price to revert, over-extend to the downside and buy at $54,000 In July. By the end of the same month, the price was back up at $70,000 and we were out of the position for profit.

It's this simple concept that I teach to my 1:1 mentees and it allows them to look at a market with a level head and idea of where they want to get in and get out.

I have made my full-time income from the forex markets for over eight years now. I favour this particular market because it is always searching for balance. In the forex markets, we have two currency pairs to consider. For one to continue going higher, the currency it is crossed with needs to continue weakening. As a result, we often see the concept of mean reversion happen more frequently and provide us as day traders with ample opportunity.  more frequently and provide us as day traders with ample opportunity.