Mean Reversion, momentum and trend-following Trading strategies
Going deep into the fantastic world of algorithmic trading can be breathtaking yet frustrating at the same time. There are many different types of trading strategies to develop, especially for newbies. It can lead to confusion, and it can be hard to decide where one should lead his direction.
To make it easier, in this article, we made a summary of different algorithmic trading strategies that exist: mean reversion, momentum, as well as trend-following strategies.
MEAN REVERSION STRATEGY
Mean reversion strategies are one of the most commonly used trading strategies in the industry. We won’t dive deep in this article, as you can read our full article about Mean Reversion Strategies here.
Now, let’s look at a different type of algorithmic trading strategy, namely momentum strategies.
Momentum strategies are pretty much the exact opposite of mean reversion strategies. Instead of betting on prices returning to some state, momentum strategies try to profit from continuing a particular move. The underlying assumption for such strategies is that price moves can hold their momentum for an extended period.
Let’s go over a few examples to clarify this.
- A classic momentum strategy is the so-called “gap and go” strategy. It is a strategy that looks for overnight gaps and is based on a continuation of this move. For instance, if stock APPLE gaps up by 3% overnight, this strategy might seek to establish a shorter-term long position on XYZ.
This is exactly the opposite of what a mean reversion strategy would do (there you would bet on reversal move).
- Another popular momentum strategy can be based on earnings, or the news event fueled price move. Since significant news events can have a lasting impact on its stock price, you could try to be early enough and bet on continuing this price move.
Furthermore, you can also combine this news event with an overnight gap to create a slightly more advanced strategy.
TREND FOLLOWING STRATEGY
Trend following strategies of the longer-term adaptation of momentum strategies. They try to identify price trends and take advantage of them by following the found trend. Usually, these are longer-term trends, but they can also be mid to short term. The exact definition of a trend depends on the chosen implementation of a trend following algorithm.
Trend-following strategies follow these principles:
- It opens many small positions in many different markets and systematically cuts losses as soon as the trend moves against open positions.
It means that the system generates more losses than profits, but profits prevail over losses in the long run. Typically, the system’s success rate is much lower than fifty percent.
This strategy stands on two pillars:
- position sizing, i.e., proper capital allocation among individual markets,
- trend signals (for example, the crossing of moving averages or a typical breakout signal where we speculate on breaking a certain price level, such as a long-term high or low).
In most cases, a trend-following strategy doesn’t rely on any fundamental model. It doesn’t focus on a specific asset class, and they are typically based on the long-short model (we open both long and short positions). This strategy is also “agnostic” as to the reasons for market behavior – the system only follows market trends. Therefore, it has nothing to do with fundamental analysis.
Diversify, Diversify, Diversify
The creation of trend following strategies was possible by the development of information technologies and automated trading systems. However, it’s not too young to evaluate the real trading results from a very long perspective. The results of many hedge funds using trend following strategies over the last thirty years correspond to theoretical assumptions.
Trend following is an asset that shows a positive slope of the yield curve and the potential to bring profits even in market slump times. Drawdowns of trend-following systems are generally shorter and up to one-third lower than drawdowns of buy-and-hold strategies. Drawdowns often appear when the market offers no opportunities and has no clear trend.
There’s one big plus: the trend-following strategy does not behave like any investment asset, i.e., there is no correlation. It makes it a useful tool for portfolio diversification.
Most investment strategies are based on the convergent risk principle, which can generate devastating losses during unexpected market events.
Trend-following and similar strategies use the divergent approach to risk and are therefore immune to market drops during crises. This system calculates with volatile growth, and it can generate significant profits under extreme market conditions. Most CTA hedge funds are long term advocates of these diversified trend-following strategies with dynamic portfolio sizing models.
Amongst the most most popular indexes that reflect the performance of the biggest trend-following CTA funds belongs:
- Altegris 40 Index
- Barclay BTOP50 Index
- Barclay CTA Index
- Barclay Systematic Traders Index
- CISDM CTA Equal Weighted Index
- Credit Suisse Managed Futures Hedge Fund Index
- iSTOXX Efficient Capital Managed Futures 20 Index
- SG CTA Index
- SG CTA Trend Index
- Stark 300 Trader Index
- Stark Systematic Trader Index
When you look at their performance, you see that the trend-following strategies have not beaten the S&P 500 index over the last ten years. These CTA funds are going through a long term crisis, and it is questionable whether they will be competitive again. In my opinion, the main reason is that these strategies are applied to daily data so that the signal lag could be prolonged in a nowadays dynamic world.
Finally, this type of diversified trend following strategy requires significant capital in millions of dollars, and for most retails traders, this is out of the question.
MARKET MAKING STRATEGY
Another common type of algorithmic trading strategies is market-making or execution based strategies. Retail traders can’t deploy this type of strategy. But this doesn’t make it entirely irrelevant, which is why I briefly want to cover it.
When big institutions such as banks or funds wish to open or close a position, they can’t just buy or sell it on the open market like you, and I would. Their position sizes are so huge that if they were to sell or buy in one go, they would push the entire market in one direction. Besides exposing their trade to everyone else, this would also lead to unfavorable entry and exit prices for them.
It is an especially big problem in a liquid market. So, what institutions do instead is open or close their positions in many different smaller orders. Sadly, dividing your order into many small orders doesn’t completely solve this problem, since they still might create a lot of pressure in one direction. That’s why they use execution based algorithms that try to find the best possible places to send out more orders without affecting the price too much.
Identifying that a big institution is currently using such an execution based algorithm allows you to trade around this algorithm. That’s why market makers often use so-called sniffing algorithms that try to find and profit from big order executions through these algorithms. High-frequency trading strategies usually fall into this category of algorithmic trading strategies.
Most of these strategies can be customized so that they are best suited for you and your preferences. Note that this article just covered general trading strategies. Regardless of what approach you want to use, it is crucial to implement solid risk management practices. Otherwise, you’re just sitting on a ticking time bomb.