How to Calculate Mean Reversion

by Diane Perez

Investors use mean reversion to reap profits from previously under-performing companies. It is a theory that whenever a financial investment significantly increases or decreases in value in a short period for no apparent reason, the pendulum will swing in the other direction. Mean reversion occurs when the price returns to its average price before the upward or downward swing. Day traders and hedge funds buy stocks or other financial securities of under-priced companies that are ready to upswing. Traders estimate when a stock is reaching the top and then sell at a profit.

1. Write the following formula: St+1 – St = a (S* - St ) + s et

2. Substitute "St" with the current cash price, called the spot price. You will find this listed on the stock exchange.

3. Substitute "a" with the mean reversion rate. The mean reversion rate is 0.0 to 0.1 in North America, according to Power Finance.

4. Substitute "S*" with the original average, known as the mean reversion level. You can locate this by examining the recent average before the significant increase or decrease in price.

5. Substitute "s" with the volatility level. NASDAQ tracks several volatility indices throughout the day.

6. Substitute "e" with the random shock to the price from t to t+1.

7. Calculate the formula to ascertain mean reversion.

Items you will need

  • Algebraic calculator

Photo Credits

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