From the July/August 2013 issue of Futures Magazine • Subscribe!

How to leverage fear with confidence

Reversion & the mean

The concept of reversion to the mean is easy to understand. Imagine a rubber band stretched taut. Think of the rubber band as the mean — the average over time, what we consider the normal state of being for the rubber band.

If you pull the center of this stretched rubber band, it will snap back quickly. This snapping back is called “reversion.” It means that the rubber band returned to its original state, or mean. This is what the market often does when it moves away from its established trend or value.

These two terms — mean and reversion — are both in play when the market moves in cycles. Markets, like the rubber band, move from a normal state (the mean) to an abnormal state, then revert back to the mean, often over-correcting, and they repeat this cycle over and over again.

“VIX entries” (below) shows a sample of trade signals on the VIX. Although not all of these entries are successful, they show that with the right filter, the volatility gauge can provide clear direction for trading the overall market.

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