Almost all trading strategies available to the retail investor can be divided into one of two camps: trend following or mean reversion.
Trend following seeks to buy something when a trend has started (or just before it takes off) and ride it as long as possible. Mean reversion strategies are designed to look at those securities that have gotten too far away from the “right” price and either go short or long and wait until it reaches the target.
It doesn’t matter whether your strategy is systematic or not, it can fit into one of these categories.
- Value investing? Mean reverting. You buy something that’s undervalued by the market and wait until the market has brought it back in line before selling.
- Passive indexing? Trend following. You put money into an index with regularity and hope the trend continues.
- Statistical arbitrage? Mean reverting. You buy when a historical correlation is at an extreme and wait until the price gets corrected.
- Global macro? Trend following. Buy Japanese stocks because the trend is up and you’re bullish on their new monetary/fiscal/regulatory/whatever policies, or go short Argentina because it’s Argentina.
- Meme stonks? Trend following. You jump on a bandwagon and hodl until the Wall Street Bets moderator says you can sell.
Trading in the Systematic World
In the systematic world, the division between these two broad categories is usually crisper and most traders are accustomed to thinking of themselves as one or the other; overt reliance on indicators, price movements, and correlations make it much easier to distinguish which camp you’re in.
Indicators can be mixed and matched by system designers. Take stochastic oscillators, for example, these can be used to mark reversals in the price in a mean reversion strategy or they could be used to determine periods of strong momentum in a trend following strategy. The same can be said for the simple moving average. A trend following strategy could use it to identify a breakout or a strong move in one direction that the trader hopes will continue. A mean reversion strategy could look for deviations from the simple moving average with and trade with the expectation that the price will return to the mean.
Depending on how you look at it, this is either exciting because you get to explore and discover new combinations that will give you the results you want, or incredibly frustrating because hard and fast rules are difficult to come by.
Systematic Trend vs Mean Reversion
Both broad strategies can be successful, however, they often yield different results.
The following table highlights some of the key differences between the two paradigms:
There are an endless way to design trading systems, however the characteristics listed above are most common in tried and true models.
The most basic version of trend following is a time series momentum strategy. Here, you have some indicators — like a pair of moving averages — that you watch for breakouts to the upside or downside. If it goes above your threshold, you jump on and go long for the ride. If it goes below, then you go short. In most cases, you’ll also apply some stop loss orders to your trade. This provides protection in case the trend doesn’t go in the right direction.
This stop loss is critical to most trend following systems. As we showed in the table above, these systems only win about 30% of their trades, otherwise there are a lot of small losses because of the stop loss orders. Those 30% of trades are usually very, very big in comparison to all of the small losses because you’re going to end up riding a lot of long term trends that may continue for years. For example, many trend followers bought gold in 2015 and held it until the market topped out in 2020 for roughly a 100% gain (doubling the initial investment).
This is how the strategy makes money.
Although most people think of trend following as a commodities and futures strategy, that’s just where it started and it’s just as applicable to stocks. Trend followers have made a killing in the market riding some big trends like Tesla or Bitcoin on the way up because their system sees it move and they ride it to the end.
Characteristics of Mean Reversion
Mean reversion systems come in a few different flavors, but the basic gist of a standard system contains some indicator that moves too far too quickly in one direction, and you take a position betting that it will go back to its average range.
As we showed in the table above, these strategies need to be right much more often than trend following because you’re usually taking positions that you expect will have a small change in price. In the example shown, we’re buying when there’s a 10% deviation from the 50-day SMA and sell when it moves back to the 50-day SMA. At most, we’re looking at a 10% return from each trade with this model, and likely less as the 50-day SMA is going to decrease after a large move downward gets averaged in.
Mean reverting strategies can open you up to big losses if you don’t control your risk. Without stops or filters in place, a mean reversion strategy can jump on a trade at the beginning of a crash because it’s expecting the price to move back up. Moreover, it could sit there and ride the position, or even add to it, as the market is going down. This is what you see in the equity curve graph above with the blue line. It bought the global financial crisis crash in 2007–2008, and the COVID crash in 2020, riding those to the bottom. Putting a safety threshold in play (red line) helped the strategy avoid the worst of these big drawdowns and greatly increase returns.
What should you trade?
Your trading system is a personal decision. We can’t prescribe a system because we don’t know you and I’m pretty sure it would be illegal to dispense specific financial advice. However, we do recommend that new traders try their hand with trend following systems first.
Why trend following?
Trend following is generally simpler to grasp, even these two managed to pull it off!
In all seriousness, entry/exit timing tends to be less important in trend following systems because of the speed from following long-term trends, making execution easier. Regularly realizing small losses isn’t easy, but limiting your downside with proper stops often prevents trend traders from prolonged drawdowns and loss of capital. Some of the correlation issues can also be mitigated by trading a diversified trend system across multiple markets as well. Additionally, trend following systems have been used by numerous successful managers over the years including John Henry (owner of the Boston Red Sox), Bill Dunn, and Richard Dennis who taught the basics of the strategy to a number of people off the street on their way to millions (see the Turtle Traders).
Regardless of the type of strategy you employ — trend following, mean reversion, or a both-and approach — we can give you the tools you need to develop and implement your strategies. We provide professional backtest software, data, and an easy-to-use-no-code user interface so you can get up and running as a systematic trader quickly. To learn more and get a chance at early access, sign up with your email address below!