Trend following VS mean reversion (and how to combine them)

 

All investment strategies can be divided into one of two camps: trend or mean reversion. One bets that the price will keep moving in the same direction … the other that it’ll head back towards its average.

• Buy and hold – trend following, because we put money in and hope for the trend to continue and take that value upwards.
• Value investing – mean reversion, because we look for something under-valued and wait for the market to bring it back into line before selling.
• Arbitrage – mean reversion, as we enter when a correlation is out of whack, and exit when the price has corrected.

We have two opposing camps, yet both work. Is there a way of using these polar opposites together, and combining trend following with mean reversion?

Here I’ll explain what the distinction is between the two, which works best, when and how …

Trend following is a simple concept to grasp, and one that’s fairly easy to apply

A trend-following investment strategy enters a market that has turned in a set direction, and looks to ride that trend in the same direction, collecting profits.

The upside for a trend follower can be considerable, as trends will often run for a long time, and beyond the expectations of market analysts. This means that these investors can have wide profit targets to take advantage of these gains.

Mean reversion, by contrast, is looking for prices to oscillate around the norm

Mean reversion strategies are based on the concept that prices can be over or under valued, and market forces will naturally bring them back into line. I like to think of the price as a piece of stretched elastic, that will naturally pull back to its natural state.

While mean reversion can be a tougher trading style to manage (especially for novices), it does tap into a very basic human urge to ‘buy cheap’, hunt out a bargain, and sell high …

Profit targets for mean reversion tend to be much tighter, which means that the mean reversion trader needs to take a very different risk-reward approach to the trend trader.

How and when to apply trend-following vs mean reversion

Neither of these investment strategies is superior to the other, but they each definitely have strengths and weaknesses, and most people have a preference of one over the other.

Here’s a summary of how each works best …

Trend following

• Easier to apply and can be more passively managed, leaving trades to run
• Tends to have wide profit targets and tight stops
• Tends to have a low win rate
• Works best over longer periods
• Trends come along less often, so there are more losing days
• Trade costs are less of an issue
• Relies on the ‘fat tail’ to be profitable – i.e. the rarer events when the market makes large moves. Early profit taking or tight stops will impede this.

Mean Reversion

• Needs more active management
• Tends to have tight profit targets and relatively wider stops
• Tends to have a high win rate
• Works best over shorter timeframes
• In day trading, these opportunities can be found all day long, day after day
• Trade costs can seriously impede profitability
• Decisive profit-taking is essential
• Works well in volatile markets to take advantage of choppy prices

Combining trend following and mean reversion

Given that the two methods directly contradict each other, is there any way we can harness the power of both methods together?

The ‘mean price’ that mean reversion traders are working on, is unlikely to be a straight line. More often, this is a moving average or a linear regression curve. The active nature of these levels can give mean-reversion traders a real headache, as the moving average moves towards the price, rather than the price towards the moving average!

But this does mean that trend bias can be built into a mean reversion strategy …

Or that trend traders can learn from mean reversion?

It’s clear that both trend traders and mean-reversion traders can use tools from each other’s armory, but it’s crucial for a trader to understand what approach their trading method needs in terms of risk/reward and win rate.

If you’re taking profits when prices have reverted to a mean level, you MUST have a high win rate. And if you’re looking for substantial wins by holding on and riding the trend, you MUST cut losses fast with a tighter stop.

If you’re looking at my Heikin Ashi Mountain system in relation to this information, we use a momentum indicator for our entry, but our profit-taking strategy is strictly in the trend-following zone – looking for substantial profit targets and cutting losers quickly.

You can get more information by following the link below …

 

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