There are many styles of trading with varying degree of sophistication but most retail traders and even some funds employ directional strategies that attempt to time continuation or reversal. These strategies are often classified as momentum and mean-reversion, respectively.
Momentum trading in its simplest form and as employed by most retail traders involves buying/shorting a security when there is a signal generated usually by a moving average cross or a breakout. The trader hopes that momentum will continue in the direction of the trade and will sell/cover in the future for a profit. The risk comes from a reversal. There are of course more sophisticated momentum strategies.
Mean-reversion trading in its simplest form involves buying/shorting when there is a signal that indicates high probability of some reversion to some mean. The trader hopes that the reversion will occur and will later sell/cover for a profit. The risk is failure to reverse towards some mean and continuation of prices along their previous direction. There are of course a lot more sophisticated mean-reversion strategies depending also on how one defines the term and the mean-reversion level.
The SPY chart below shows the occurrence of the last 50/200 golden cross on April 20, 2016 that generated a momentum buy signal. The two indicator panes show the momentum indicator MA(50) — MA(200) and a proprietary mean reversion indicator called MR5 based on probability theory.
It may be seen how momentum traders usually buy/short top/bottoms in the short-term and mean-reversion traders usually buy/short bottoms/tops in the short-term.
In a nutshell then, trading is hard because in many cases traders go against the short-term trend. If they have a good strategy they are rewarded for the risk. If not, they are punished for foolishly taking risk. In the process they assist in price discovery.
By the way, since April 20, 2016, MR5 mean-reversion has outperformed the 50/200 golden cross that is also the buy and hold strategy. Below are simulated performance details.
Note that all backtests include $0.01 commission per share and equity is fully invested. All entry and exit trades occur at the next open to prevent look-ahead bias. Period of the test: 04/20/2016–08/18/2017.
It appears that mean-reversion is rewarded for excessive risk arising from buying dips and Sharpe ratio is substantially higher as compared to the 50/200 cross and buy and hold since 04/20/2016. However, this may be a special period and not representative of a specific behavior.
Trading mean-reversion strategies is even harder than trading momentum strategies. Although the rewards can be larger, this type of trading is exceptionally hard and only for those who understand the risks and can withstand the pressure. But trading is hard in general. Momentum traders must exercise discipline and follow the signals. Actually, some have even claimed that the signals are not as important as the discipline and psychology. This is partly true but good psychology and discipline must be backed by an edge (positive expectation) otherwise they do not suffice. But on the other hand, edge without discipline is no edge at all.
Finally, many traders, especially the new crypto traders, think they are trading but in reality they are manipulated in a game where they are enticed to increase their stakes so that their loss will be maximum when the proper time comes and some market forces or political events can be blamed instead of those who have conceived the game.
This article was originally published in Price Action Lab Blog
If you have any questions or comments, happy to connect on Twitter:@mikeharrisNY
About the author: Michael Harris is a trader and best selling author. He is also the developer of the first commercial software for identifying parameter-less patterns in price action 17 years ago. In the last seven years he has worked on the development of DLPAL, a software program that can be used to identify short-term anomalies in market data for use with fixed and machine learning models. Click here for more.