Types of trading strategies

Types of trading strategies

There are two types of trading strategies: momentum strategies and mean-reverting strategies.

Any trading strategy you choose to implement will fall into either the momentum or mean reverting category.

What are momentum strategies?

Momentum strategies are trading approaches that focus on the idea that assets or markets that are already exhibiting strong price movements are likely to continue in the same direction.

These strategies assume that assets that have shown upward or downward momentum will continue to gain or lose value, respectively, for a certain period.

Put simply, when a stock is following a trend, it is likely to remain in that trend for a certain period. Momentum strategies take advantage of these trend movements.

What are mean reversion strategies?

Mean reversion strategies in trading are approaches that operate on the principle that asset prices tend to move back toward their average or mean value after deviating from it.

This strategy assumes that extreme price movements will be followed by a correction, returning the price to its average level.

In simple terms, when something experiences an upward movement, it becomes less likely to continue rising and more likely to reverse and decline. and then when it comes down, it becomes less likely to continue falling and more likely to reverse and rise.

This behavior implies that the asset tends to revert back to its average price every time it deviates from it.

This type of behavior is commonly referred to as mean reversion.

Now which type of behavior, momentum or mean reversion, do you believe the market exhibit more?

The market exhibits both sometimes momentum behavior, where it tends to move in a particular direction, and sometimes mean reversion behavior. goes up and down.

Whenever the overall market demonstrates momentum, many individual stocks are likely to exhibit momentum as well. Conversely, when the market is in a mean-reverting phase, a significant number of stocks are expected to follow a mean-reversion pattern.

Contrary to popular belief that the market predominantly exhibits momentum behavior, it is, in fact, mean reverting about 80% of the time, while staying in a momentum state for only around 20% of the time.

The reason for this false belief is our human tendency to overemphasize momentum due to the memorable instances of certain well-known stocks like Apple, Amazon, and Google that experienced significant and continuous upward movement. We tend to recall the exceptional cases of stocks that consistently rise or fall.

However, we often overlook the numerous stocks that exhibit a pattern of going up and coming back down, or simply remaining relatively stable. In reality, such instances where nothing extraordinary occurs represent the majority of cases in the market.

So most of the time we are actually in mean reversion.

Both momentum and mean reversion strategies can be effective, but it is important to understand that they operate in different ways. Therefore, your approach needs to be tailored accordingly for each strategy.

Example:

When implementing a mean-reverting strategy, it is essential to comprehend that if a stock exhibits mean-reverting behavior, you would short the stock when it rises and buy the stock when it falls, repeating this process consistently.

However, it is worth noting that there may be instances where the stock undergoes a momentum shift, resulting in potential losses as part of the mean reversion strategy.

In a mean-reverting strategy, you typically aim to make small profits consistently. However, there may be instances where you experience losses at certain points in the strategy.

In momentum strategies, the objective is to identify stocks that are expected to make significant moves in a particular direction, and you aim to capitalize on those moves.

However, it is important to acknowledge that most of the time, the stock may not exhibit any substantial movement. and then, there may come a point when the stock starts to move significantly in the anticipated direction.

In a momentum strategy, you have the expectation that a stock will increase in value, leading you to make a purchase. However, the stock may instead decline, resulting in a loss. This pattern may repeat several times, with buying attempts followed by further falls. However, there comes a point when you make a purchase and the stock finally moves in the expected direction, allowing you to generate significant profits.

So in momentum trading, the goal is to aim for substantial gains by predicting significant market moves. However, it involves taking multiple attempts where you may incur losses when predictions fail. Yet, there will be instances where your prediction is correct, resulting in significant profit.

It can be likened to swinging for a home run multiple times, accepting smaller losses along the way, and eventually hitting a successful trade that yields substantial returns.

Indeed, both strategies operate differently. In a momentum strategy, the focus is on aiming for significant profits, which may involve enduring several small losses along the way. On the other hand, in a mean-reverting strategy, the goal is to accumulate smaller profits consistently, but there may be a point where you experience a loss.

Thus, the trade-off lies in pursuing potentially substantial gains with frequent small losses in momentum trading versus seeking consistent smaller profits with occasional losses in mean-reverting trading.

Now, which one is better?

Both momentum and mean-reversion strategies have their merits, and a favorable approach is to implement both strategies simultaneously.

Beginning with a mean-reverting strategy is often advantageous due to its positive impact on emotional well-being.

What I mean by that is when you commence trading, engaging in a mean-reverting strategy allows you to experience daily wins, which can be emotionally satisfying. You will have a majority of winning days with small profits and only a few days with losses.

However, when employing a momentum strategy, it can be emotionally more challenging. In this approach, you may encounter consistent losses for the majority of trading days, with the potential for substantial gains occurring only on a few select days. but its makes for all of these losses.

Missing out on those significant gain days can have a profound emotional impact on you.

As we discussed, the optimal approach is to implement both strategies simultaneously. During periods when the market demonstrates mean-reverting behavior, your mean-reverting strategy will generate profits while your momentum strategy may incur losses.

Conversely, when the market enters a momentum phase, your mean-reverting strategy may result in losses, but your momentum strategy has the potential to yield substantial gains. By combining the two strategies, that are negatively correlated with one another, you ensure a consistent profit potential throughout different market conditions.

We aim to avoid relying solely on market behavior since it is unpredictable and challenging to foresee its movements accurately.

In the upcoming article, we will delve into the process of selecting stocks tailored to specific types of strategies.

If you want to learn more about mean reversion and momentum check out this research article by Alina F. Serban

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