Mean reversion

When prices move too far, too fast, there is often a return towards what are regarded as more ‘normal’ prices, perhaps around a moving average. This is known as reversion to the mean.

Consider a situation in which the gap between current prices and the 55-day moving average is the largest it has been for 12 months. This may be taken as a warning signal that prices and the 55-day moving average will soon converge.

Somewhat more reliable signals can be obtained using a tool such as Bollinger Bands. These bands reflect the volatility of a given security or currency pair. Explaining Bollinger Bands and strategies that make use of them in detail would fill a book of its own, so this section will just cover some of the key basics.