1 – M2L6 01 Intro V3

In this lesson, we’ll learn about two properties of financial assets, mean reversion, and co-integration. Based on these properties, we will learn about the trading strategy called, Paris trading. From there, we will examine the more general strategy called, mean reversion trading. First, let’s preview some concepts. What is mean reversion? A mean reverting time series is one that tends to move back and forth around some constant value. When applying mean reversion to a single stock, we could check when the stock price deviates significantly from the mean. For example, we may see a stock decline significantly below its historical average. Assuming the stock will revert to its mean, we may buy the stock and anticipate that it will increase back to its original price. There is still the risk that the stock price does not return to its historical mean. For example, the stock may settle at its new, lower value. Even worse, it might just keep declining. In practice it’s more common to apply mean reversion to a pair of stocks. Let’s imagine that two companies are economically linked. By economically linked, I mean that they may be in the same line of business, may be operating in the same country, and may have similar types of products or customers. We can imagine that the stock prices of these two companies may also move up and down in a similar way. Since these companies move up together and down together, they appear to have a consistent relationship that we can expect will continue into the near future. So, when we see the prices of these two similar companies diverge significantly, we may make trading decisions based on the assumption that this divergence is temporary. The view of our trading strategy is that later in the future, the prices will settle back to their original relationship. We’ll examine these concepts in more detail in the rest of this lesson.

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