Sunday, March 26, 2006

Mean Reversion: How Often Does It Occur?

Recent posts have looked at the market's lack of trending and, indeed, its tendency to reverse moves. Does this suggest that the market tends to revert to mean trading prices? If so, might we find tradable strategies from this tendency?

I went back to March, 2003 (N = 773) and investigated each day of performance in the Dow Jones Industrial Average (DIA). I computed the previous day's average price simply as the average of the open-high-low-close. I then looked to see how often this average price was touched during the following day's trade.

It turns out that we revert to this mean trading price approximately 63% of the time. Since February of this year, that proportion has risen to over 70%. Are there variables that predict an even greater occurrence of this reversion? Do we see different levels of reversion on different time frames? Lots of good research questions here. Stay tuned.