Reversion to the Mean: Card Counting & Playing The Market

The mean or the average of the count in blackjack is zero as there are an equal number of low cards and high cards in any shoe or complete number of decks.  The further away the count is from zero, the stronger the tendency that it will move back toward the mean.  Professional card counters gain an advantage by wagering larger bets during positive deviations in the count when there is a greater probability that favorable high cards will be dealt as the count returns to its center of zero.

In the financial world, conventional wisdom is to buy when a  stock is undervalued and to sell when the price is  high. The law of regression to the mean states that probability wise, extreme values are more likely to be followed by less extreme values. Reversion trading is based on buying or selling stocks that are out of line with their “normal” pricing. Traders profit when  market prices return to their average just as card counters do when positive counts move back to the mean count of zero.

Although reversion trading is based on mathematical law, there’s no guarantee that this approach will yield a profit. The million dollar question is what is the true mean of a stock or commodity?  Variables used to forecast the market such as P/E ratios, interest rates, and investor confidence, just to name a few, are constantly changing.   In addition to the ever changing nature of market variables, another challenge is determining the appropriate time horizon for the mean price. Many traders have learned the hard way that  models that were successful in the past may no longer produce a profit, or may have been an aberration that was the beneficiary of chance.

In the game of 21 as well as the financial markets, it is possible to forecast the future and capitalize on deviations from the mean if the key variables are captured and weighed properly and the true mean  and its corresponding time horizon are determined.  As compared to the financial world, blackjack offers a static predictive measure (the count), as well as an explicit mean and time horizon. Unlike a stock or commodity, in 21, what goes up truly must come down.  This makes the return on investment in blackjack unmatched by that of any trading model in the financial world.