Mean reversion indicators are indicators which tend to revert back to some moving average over and over again, thereby offering traders more predictability over the financial markets. Mean reversion works well for some periods at a time, but it can also run into problems as for some periods the mean reversion works in reverse, and instead of the indicator reverting back to its average value, the indicator can remain unchanged for days, and instead it is the moving average that starts to move and converges with the indicator value. So things can become quite confusing when trading the markets using mean reversion indicators, but in general they do have some predictive power which all wise traders know how to use.
A mean reversion indicator can be something as simple as a moving average, such as the 10 day moving average, some traders believe that the market keeps crossing through this moving average every now and then, but the indicator itself is lagging the market and therefore it can lead to all sorts of wrong impressions, about where the market is going next. Even something as simple as the 10 day moving average can be used together with other indicators, especially momentum indicators, to make up a more reliable trading system, one that can detect when the market will move, and when the market will stay flat and the moving average will move instead. The anticipation of the two values converging again is easy, but the timing is not periodic or predictable, and there is no easy way to solve this problem, even with the use of additional indicators.
A well known mean reversion indicator is the Option Volatility Index, or VIX, this indicator which measures investor fear in the market, tends to move in the opposite direction that the stock market does, it is used by many traders as a way to gauge market risk, and it is also used in mean reversion mode. Some traders use the VIX index along with its 10 day moving average, and always anticipate that the daily value of the VIX and its 10 day moving average are bound to meet again. The anticipation is generally correct, but the expected convergence might happen in the reversed way, so that the moving average slowly moves while the VIX index itself hardly moves at all. Traders simply expect that when the index diverges too much away from its moving average, say to the upside, while stocks drop, the VIX index is bound to revert back down to its 10 day moving average, and therefore stocks will rally as a result, and indeed sometimes this is what happens. But if the convergence happens in the reversed way, what can really happen is that stocks remain flat for days, they do not really rally at all, hence the VIX index remains also overall flat, and instead of the VIX index falling lower, it is its 10 day moving average which is rising higher, so the two will converge and meet at a higher level. This is the potential trap for new traders utilizing the VIX indicator in its mean reversion mode, therefore things are not as simple as one would have hoped, as the market can still fool these new traders despite all the importance of the VIX indicator.
Despite all the confusion, the VIX indicator is a non linear indicator, not perfectly related to stock market price and it therefore works better as a leading indicator during market turning points, compared to a simple stock market 10 day moving average, or anything to do with market price alone.
The above chart shows the SP500 index (above) and the VIX indicator along with its 10 day moving average (below). The VIX indicator is used here in its mean reversion mode, and one can see how every time the VIX diverges too much away from its 10 day moving average, it tends to move in the opposite direction soon afterwards, and the SP500 stock index moves in the opposite direction that the VIX indicator moves.
Each pair of like colour arrows on the above chart shows such a pattern of mean reversion, notice the pair of green arrows on the right, the VIX indicator becomes stuck in a tight range, and it is the moving average that moves higher for a while instead of the VIX falling, finally the VIX and the SP500 reverse direction, but this is not always the case. Sometimes a reversal may not happen at all, as the convergence between the VIX index and its moving average can happen in the reversed way as here, but prices can stabilize at those levels, and both the VIX and the SP500 can keep on moving in the same direction later, in the direction they had before, without really reversing at all.
Despite all the potential traps, the VIX index can be used extensively in its mean reversion mode, and many profitable trading signals can be inferred from this indicator. Wise traders use this indicator together with other methods of analysis, such as short term fundamental analysis and swing trading theory. So as to be more certain of what is most likely to happen, and be able to avoid confusion exactly as it happens when the reversion convergence process happens in the reversed way. Ambiguity and confusion will always exist in the markets because nothing is ever 100% certain, all figures and opinions traders infer from market analysis relate to probability and not absolute certainty. The VIX index however is much better to use than a simple price based moving average, because it is more of a leading indicator.
