Mean reversion in trading sounds logical, but is it reliable? Discover the truth behind stock price behavior and how psychology, randomness, and expectation affect it. “Bhaiya, yeh stock ₹350 pe tha last month… abhi ₹410 ho gaya hai. Wapas neeche toh aayega na?”
Sound familiar?
This is one of the most common thought processes among Indian retail traders and learners. The belief that every stock price will “come back to normal” is so widespread that it becomes a dangerous default assumption. This concept — Mean Reversion in Trading — is rooted in a fascinating mathematical and psychological idea. And yet, it is often misunderstood and misapplied.
In this blog, let’s decode what mean reversion really is, where it works, when it fails miserably, and how your own expectations — not the stock — can become your biggest enemy.
📚 1. What Is Mean Reversion in Trading?
Understanding the Statistical Core
Mean reversion is the idea that prices, over time, tend to move back toward their average or “mean.” It’s a simplified extension of a statistical concept called regression toward the mean, which states that extreme outcomes are likely to be followed by more moderate ones.
In trading, this is applied as:
- A stock that rises sharply is expected to fall back.
- A stock that drops unusually low is expected to bounce back.
But do they always revert? That’s where it gets tricky.
🔎 Example:
If Infosys goes from ₹1,400 to ₹1,700, many assume it’s “overvalued” and will fall back. But what if their earnings improved and future prospects changed?
Key Insight:
Just because something moved far from the mean doesn’t guarantee it will come back. The reason behind the move matters.
🧠 2. Regression Toward the Mean: Galton’s Tall-Tale Mistake
The Father of Misinterpretation
Sir Francis Galton tried to prove that tall fathers produced equally tall sons. But he missed a big detail — mothers’ genetics. His flawed conclusion led to the term “regression toward mediocrity,” later reframed as regression toward the mean.
It simply means that in any system with variability and randomness:
- Extremely high or low values tend to get “pulled” closer to the average on the next attempt.
💡 In trading, this implies:
- Stocks that shoot up unusually high are often followed by more normal movements.
- But this doesn’t mean the “mean” is a magical price to which it must return.
🎯 Mindset Shift:
Don’t treat the mean like a magnet. It’s more like a weather average — useful, but not guaranteed.
📉 3. Why Traders Misuse Mean Reversion
The Psychology of Expectation
We love predictability. So, our brain takes shortcuts.
“It went too high — it has to fall.”
“It fell too much — it has to bounce.”
This is expectation bias, not analysis.
🔻 Where we go wrong:
- We assume today’s price is wrong and expect it to correct.
- We ignore new information, earnings, or changing fundamentals.
- We trust history blindly, forgetting that the context has changed.
🎯 Relatable Analogy:
If you scored 95% in one exam, it doesn’t mean your next score must be lower. Maybe you studied better. Maybe the exam was easier. Or maybe you’re just leveling up!
🔍 4. When Mean Reversion Works in Trading
Understanding Randomness vs. Reality
For mean reversion to apply, three things must hold true:
- The true value of the stock hasn’t changed.
- The current price deviates due to temporary factors (news, hype, panic).
- This deviation is largely random.
✅ When It Works:
- Overreaction to fake news (e.g., a false bankruptcy rumor).
- Emotional market phases (greed, fear, euphoria).
- Technical overshoots (like RSI going above 80).
📊 Example:
If a fundamentally sound stock crashes due to temporary panic (like a geopolitical headline), and nothing about the business has changed — mean reversion becomes likely.
🎯 Actionable Tip:
Before betting on reversion, ask:
Is this a random move or is the business genuinely transforming?
🚫 5. When Mean Reversion Fails
Permanent Change ≠ Temporary Noise
Some stock moves are not just noise — they reflect a permanent shift.
🚫 Examples:
- A company discovers a breakthrough product → Stock surges and stays elevated.
- Fraud is revealed → Price collapses and never recovers.
In these cases, there is no mean to revert to, because the “normal” itself has changed.
💥 Popular Mistake:
Averaging down endlessly in a stock expecting it to return, while its business is dying. (Think Yes Bank, DHFL, Jet Airways.)
🎯 Mindset Shift:
Stop expecting past prices to be “fair.” The market doesn’t owe you a bounce-back.
📈 6. How to Use Mean Reversion Correctly in Trading Strategy
A Tool, Not a Rule
To use mean reversion intelligently, follow this approach:
✅ 🔑 Checklist Before Expecting Mean Reversion
- Is the company still fundamentally strong?
- Was the price move news-based or purely emotional?
- Are technical indicators showing oversold/overbought?
- Is there historical context of reversion for this stock?
- Is market sentiment extremely polarized?
🧠 What You Should Remember:
“Mean reversion is not a guarantee — it’s a probability. And probabilities are only useful when combined with logic and context.”
🧠 7. Market Psychology and Randomness: Why Prices Deviate
The Human Mind in Trading
Stock prices are determined by human behavior, not pure math.
📌 Mass psychology → panic, greed, herd behavior
📌 Rumors, FOMO, news cycles → randomness
📌 Technical levels → self-fulfilling prophecies
That’s why:
- Short-term moves often deviate from fundamentals.
- Long-term prices are more rational.
🎯 Analogy:
Think of prices like traffic during Ganesh Visarjan. Temporary chaos. But eventually, order returns — if the road (company) is still solid.
🏁 Conclusion: Be Wary of the Mean That Misleads
In the Indian market, where narratives dominate and volatility is frequent, mean reversion in trading can be a helpful lens — but only if used wisely.
Not every spike is fake. Not every dip is a bargain.
Before betting on “normal”, ask — has the game changed?
Train your eyes not just to see patterns, but to question them.
That’s the difference between a hopeful trader and a strategic one.
📣 Call to Action
🧭 Have you ever held onto a stock hoping it would bounce back — only to watch it sink further?
Drop your story in the comments — your experience might save someone else from making the same mistake.💬 Share this blog with a friend who needs a reality check on mean reversion!
What is mean reversion in trading?
Mean reversion is the idea that stock prices eventually return to their average level after extreme moves.
Does mean reversion work for all stocks?
No. It works best when the price move is due to temporary or random factors, not permanent changes.
Is mean reversion a reliable trading strategy?
It’s useful but not foolproof. Use it with other indicators like fundamentals and technicals.
Why do traders expect prices to revert?
Because of expectation bias — we wrongly assume that what goes up must come down, and vice versa.
How can I avoid false mean reversion signals?
Check if the price move is due to emotions, not earnings or business changes. Don’t average down blindly.