The concept of mean reversion is such an important part of the tastytrade philosophy that an argument could be made for its inclusion in the firm's legal name.
In finance, mean reversion is the assumption that a financial instrument's price will tend to move to the average price over time.
If we apply that definition to volatility, then it is the assumption that an option's volatility price will tend to move toward its average over time.
Consequently, a mean reversion trade expresses the thesis that an asset has deviated too far from its real value – or at least from its mean price – and that opportunities for profit exist when reversion to the mean occurs.
On the tastytrade network we often leverage Implied Volatility Rank, or IVR, to help identify mean reversion opportunities. However, some recently aired episodes on the tastytrade financial network examine this concept in greater detail and highlight some additional metrics traders might consider leveraging to help uncover opportunities in the marketplace.
On an episode of Options Jive, hosts Tom Sosnoff and Tony Battista explain that a product's "mean" is heavily dependent on the time period used to produce the calculation. As you can see in the example below, there can be a significant difference between the 50-day and 20-day means:
If the market price for volatility (i.e. implied volatility) in the above example was 14, one's perspective on whether implied volatility was "cheap" or "expensive" would depend heavily on which mean was used in the analysis.
It's for this reason that Tom and Tony suggest on Options Jive that traders might be best served using a mean that most closely matches the days-to-expiration (DTE) of the option they are considering trading. For example, an option that expires in 45 days may be best evaluated against a calculation of the 50-day mean (as opposed to 20-day or 100-day).
Tom and Tony also discuss a weighted-average approach, which takes into account a wider time frame of data and can then be customized to assign greater weighting to the short, middle, or long-term.
A recently aired episode of Market Measures picks up where Options Jive left off and highlights research done by the tastytrade team that measures the PnL performance of some strategies that were backtested using the historical mean as a basis for trade deployment.
We suggest you watch both episodes in their entirety for the best possible understanding of how this information may affect your own approach to options trading.
If you have any questions or feedback on mean reversion, we hope you'll reach out at email@example.com.
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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.