Let’s talk about mean reversion and why it’s an important concept in the world of options trading.
What is Mean Reversion?
If we were going to boil it down to one simple concept, mean reversion is:
What goes up must come down.
And of course contrarily, what goes down must come up!
In other words, variables like stock prices, implied volatility and volume can all be “averaged.” If the current data deviates far from the average, mean reversion implies that the data will meet the average once again.
As you can likely imagine, that methodology is extremely useful in the stock market and in options trading.
How to Trade Mean Reversion
There are a variety of ways to trade mean reversion in the stock market and with options. The most popular way to read mean reversion is through indicators like the moving averages.
Let’s look at a few examples of how large deviations between stock price and moving average can be a powerful contrarian trading signal.
VOCAB CHECK: Contrarian Trading
Contrarian trading involves trading the opposite of the current trend. Contrarian traders cast trades in hopes that a trend reversal is coming.
At Market Rebellion, we’re all about mean reversion trading. This means we’re constantly on the lookout for price extremes and volatility, because we believe that they will eventually revert back to their mean over time. It’s kind of like a boomerang.
Mean Reversion and Moving Averages
For instance, take a look at QQQ — the popular Invesco ETF built to mirror the Nasdaq. Below, we’ll look at 6 instances where the stock price has deviated far from the 50-day moving average, and what happened afterward.
In each of the instances, except for the final frame which shows a present day diversion, a wide deviation from the moving average has led to a reversion! Notice that the moving average isn’t really the line that’s doing the leg work here. If the moving average is walking, the stock price is sprinting up and down the chart, turning back around whenever it strays too far out of range of the moving average.
Of course the next question would be, how far is too far? You could average that too! For example, of the five instances shown above (we can’t count the sixth since we don’t know the outcome), the average maximum deviation is 10.2%! That’s the average point at which the stock turns back around for a trip to the moving average.
While we’re only analyzing the 5 most recent instances in this case, one could stretch this data analysis out as far, or as near, as they wanted. In any case, by using this rough average to enter trades in the QQQ, traders would have been able to successfully identify 3 out of 5 of the instances shown above — with the remaining two not straying far enough to have “triggered” the deviation.
However, when it comes to options trading, mean reversion has a few more meanings.
Mean Reversion and Implied Volatility
Here’s one important thing to know about implied volatility and options trading:
As implied volatility rises, long option prices rise. As implied volatility drops, long option prices drop.
Implied volatility is one of the most important metrics to understand when trading options. You could be directionally right about your stock price prediction, but still lose money to theta and implied volatility decay if you aren’t careful. On the other hand, you could use a strong foundation of knowledge in implied volatility (or IV) to take advantage of instances where the IV is bound to revert to the mean.
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Again, recall that “mean reverting” really just means that things in the stock market have a tendency to balance themselves out over time. Of course, with implied volatility, we have to navigate around binary events like earnings announcements. Those are instances where the implied volatility almost always takes the same shape — a steady rise heading into the event, followed by a sharp drop afterwards, once the news is already out.
However, in normal instances where there is no event on the horizon, implied volatility can still ebb and flow as market conditions change! This is where mean reversion can be a useful tool to predict option pricing.
We can use implied volatility mean reversion to predict when a trade should be rolled rather than closed, and to predict opportune times to enter or exit trades! You can even use implied volatility mean reversion to decide what style of option strategy you’ll opt for!
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For instance, in an environment where mean implied volatility is relatively high, you would likely opt for a vega negative strategy like a credit spread! Credit spreads are short vertical spreads that allow traders to take advantage of overpriced options.
Essentially, credit spreads are all about selling expensive options to risk-oriented traders, in the hopes that the spreads expire worthless, or that the stock doesn’t move quickly, which will (hopefully) sink the implied volatility! When implied volatility decreases, credit spreads typically gain value.
Inversely, if the implied volatility was often relatively low, you would more likely opt for a debit spread! Low implied volatility implies that options are generally underpriced, or at least that they’re pricing in a small move. In the event that a large move does occur, debit spreads (or even simple long options!) will be the most appropriate tool to exploit that move!
The Bottom Line
This is really just the tip of the iceberg when it comes to mean reversion. There are a cornucopia of mean reversion trading strategies that traders use to make predictions about the market. And it’s important to remember that none of them are infallible.
The best trading strategy is one that utilizes multiple trading set-ups in order to develop a thesis! That’s where it pays to have an understanding of technical analysis, options strategies, and more.
Sound like a lot to take in? It’s okay — take your hands off the wheel and check out Rebel Weekly. Inside Rebel Weekly, licensed CMT’s and professional option traders come together to craft two trades based on these principles every single week, complete with triggers, entry & exit levels, and specific option contracts! Skip the trial and error, jump over the learning curve, and try Rebel Weekly today.
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Rebel Weekly
Every week, we deliver two options trade ideas to you, alongside step-by-step instructions about how and when to execute the trades.
What you get:
- Detailed Trade Write-Ups
- Trade Explanation Video
- Entry, Exit & Stop-Loss Triggers
- Chart Analysis & Technical Levels
- VIP Friday Virtual Cocktail Hour
- Swing Trading
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Rebel Weekly
Every week, we deliver two options trade ideas to you, alongside step-by-step instructions about how and when to execute the trades.
What you get:
- Detailed Trade Write-Ups
- Trade Explanation Video
- Entry, Exit & Stop-Loss Triggers
- Chart Analysis & Technical Levels
- VIP Friday Virtual Cocktail Hour
- SAVE Over 58%
- Swing Trading
- Beginner
