Last Updated on 17 November, 2020 by Samuelsson
Trend trading and mean reversion trading could rightfully be said to be the two biggest and most popular trading styles out there. And while both are used extensively, they capitalize on very different market behavior.
Trend following and mean reversion both are two great trading forms and you really cannot say that one is better than the other. It all depends on the type of strategy and market you’re attempting to trade, as well as your personal preferences.
In this article we’ll be comparing mean reversion to trend following, to help you understand the advantages and disadvantages of both trading styles.
We will start by covering each trading style on its own, and then go on to the comparison! You will also get to see real examples of trend following and mean reversion strategies!
What Is Mean Reversion?
Mean reversion is when a market tends to swing around its average, or “mean”, effectively producing outsize bullish and bearish moves that are corrected by a move in the opposite direction. When a market has moved too much to the upside, we say that it’s overbought. Conversely, if it has moved too much to the downside, we say that it’s oversold.
The goal in mean reversion trading is to identify when a market has entered oversold or overbought territory. The image below attempts to illustrate a mean-reverting market. Later in the article, we’ll look closer at ways that you can define these turning points.
General Characteristics of Mean Reversion Strategies
Mean reversion strategies tend to have quite a high win rate. It’s not uncommon to see win rates as high as 80 or 85%. This is to some extent because that many mean reversion strategies use conditional exits that demand that the market has bounced back. This makes it highly likely that we’re in a profit when the exit signal occurs.
The fact that winners are quite many, has the effect that mean reversion strategies have quite small winners and a few big losers. Many traders see this as an advantage, since it makes it easier to trade the strategy from a psychological standpoint.
Another thing to keep in mind is that mean reversion strategies will require a big stop loss. The more the market goes against you, the more oversold it is, and the better the edge gets. You could say that the market gets more prone to “snapping back” as it moves against you. As such, you don’t want to cut your losses too early.
Our approach to mean reversion strategies is to not use a stop loss at all. This is possible only because we trade a lot of strategies automated, and may cut back on the capital we allot to each strategy. Thus, the risk isn’t that big anyway.
If you’re interested in how we trade our own trading strategies, you may have a closer look at our complete guide to algorithmic trading!
Disadvantages of Mean Reversion Strategies
Some of the disadvantages of mean reversion strategies are:
- Since mean reversion strategies require a big stop loss for you not to be stopped out too early, you will have to keep your position size smaller than you would with other strategies, in order to not risk more than your set limit. This is a clear disadvantage, since a small position size also means that you’ll make less money on each trade.
- Often you’re entering mean reversion trades when everything looks ugly and pessimistic, which may make it hard to pull the trigger.
- Another disadvantage is that mean reversion strategies tend to not work that well in less volatile periods. You need some volatility so that the market makes those swings that you attempt to profit from
Advantages of Mean Reversion Strategies
Some of the advantages of mean reversion strategies are that:
- They have a short holding period. If you trade the daily timeframe, you often don’t hold positions longer than 2-10 days.
- They tend to work in volatile market conditions. For instance, many believe that mean reversion stopped working during the volatility period following the financial crisis in 2008. In reality, they thrived!
- The high winning percentage may make it easier to pull the trigger
All in all, mean reversion is a great trading form that suits many traders!
What Is Trend Following
Trend following, on the other hand, relies on the very opposite tendency to that of mean reversion. Instead of taking a contrarian approach by assuming that the market has become oversold/overbought, we enter in the direction of the strength and momentum.
This is done under the assumption that market trends are worth riding along, and that market strength isn’t a sign of a pending correction, as with mean reversion strategies. Still, you could be using trend following and mean reversion strategies in the same market, provided that they use different methods to define when a market shows strength.
Characteristic of trend following strategies
While mean reversion strategies tend to have quite many winners, trend following strategies tend to have few but big winners. As trend traders we’re trying to catch the longer trends, and will inevitably act on quite a lot of false signals before we stumble upon a trade that compensates for all the losses.
This means that trend following can be a hard trading form to execute, since you’ll have to deal with quite long losing streaks. In addition, it’s important that you never miss a trade, since it might be that one trade which will turn the tables profit-wise.
Trend following strategies hold on to positions for longer periods than mean reversion strategies, since they’ll try to ride profitable trends for as long as possible.
Disadvantages of trend following strategies:
- You will have to withstand a lot of false signals. At the start of a new trend, it’s impossible to know whether the market is going to jump into a new long term trend, or just turn back and cause a loss. Being wrong a lot is inevitable in trend following, which is why you’ll have to cope with being wrong a lot of the time as a trend follower.
- The low hit-rate, which may be as low as 20%, means that trend following strategies can be hard to follow at times. Just imagine if you had to pull the trigger, after experiencing your 10th loss in a row. Not that compelling, right?
- You should never miss a trade! Since most of your profits will be delivered from a very small portion of all the trades you execute, it’s paramount that you don’t miss one of those trades. And since you never can tell beforehand which trades that are going to be the profitable ones, you need to take all the signals. Otherwise, you risk just taking the losing trades, and missing out on the one trade that might make up for all your earlier losses!
Advantages of trend following strategies
- Since you’re attempting to catch trends at the very beginning, it means that you’re going to be in for most of the trends in the market. And since trends may last for years, you could be in for a long, profitable ride!
- Since you’re attempting to catch and ride the large swings in a market, your entries don’t need to be that exact. The most important thing is to catch the bulk of the big trends, which will pay for all the trades that don’t go that well.
- Trend following strategies have much fewer transactions compared to mean reversion strategies, and a much higher average trade. This means that one of the biggest hurdles in other trading styles, namely transactional costs, isn’t that much of an issue to you. This is a great advantage since many trading strategies will look great before transactional costs have been deducted, but barely tradable after.
- Spinning off the first and second points, trend following strategies automatically means that you apply the concept of cutting your losses early and letting your profits run. This is a concept that some of the most famous traders have attributed a lot of their success to, and that is important to always keep in mind!
Mean Reversion Strategies
As we mentioned earlier, the main objective of a mean reversion trading strategy is to identify when a market has turned oversold or overbought, in order to know when to enter.
There are many ways you can define this, and we’ll have a look at a few examples:
1. The RSI-2 Strategy
The RSI-2 Trading strategy is one of the perhaps most well-known mean reversion trading strategies. Using just two conditions for the entry, this is a trading strategy that has been working for a long time.
The rules to enter a trade are:
- The market is above its 200-period moving average
- The 2-period RSI crosses below 10
Then you exit once the 2-period RSI crosses above an upper threshold, such as 60.
Here is the equity curve for this very strategy, applied to the S&P-500 market.
2.The Bollinger Bands Strategy
Another way to define an oversold market, is with Bollinger bands.
In short, the Bollinger bands indicator consists of three lines, which are the middle band which is a moving average, plus one upper band and one lower band, both located two standard deviations away from the middle band. In our complete guide to Bollinger bands, we go deeper into this topic and much more!
By requiring that the market closes below the lower Bollinger band, we define that it’s becoming oversold and is about to revert soon. Then we just have to wait for the correction, which is defined as the market closing above the middle band.
So, the rules are that you:
- Go long if the market crosses below the lower Bollinger band.
- Exit the position once the market crosses above the middle band.
Here you see the backtest for these very rules:
The last example strategy on our list is the double seven trading strategy. As with the RSI-2 strategy, this is a trading strategy that’s quite well-know, but that stills works decently.
Instead of using a trading indicator to define oversold levels, the double-seven strategy uses a price pattern. More specifically, it defines an oversold market as one closing at its seven day low, which becomes the entry signal.
To assure that the market is in a bullish state, we also require that the close is above its 200-period moving average.
Then, to exit, you normally wait for the market to close at it’s 7-day high, signaling that the reversion to the mean is complete.
So, the rules are:
- Go long if the market closes at a new 7-day low, and is below its 200 period moving average.
- Exit the position once the market makes a new 7-day high.
Here is the backtest report for these rules:
Trend Following Trading Strategies
Now that you have got to see some examples of fully functional mean reversion strategies, it’s time to have a look at a trend following strategy as well.
Now finding a trend following strategy that works well in the stock market is much harder than finding a mean reversion strategy.
In general, you’ll be more successful applying trend following to other securities, like commodities.
Still, below we’ll take a look at one simple trend-following logic that has been successful in the S&P-500 market.
20 Day Breakout
Some of the earliest trend following strategies that came about, were those that bought on a 20-period high, and went short on a 20-period low. This is the strategy we are going to present below.
Now, due to the long term bullish bias of the equities market, we’ll skip the short side and only keep the long side of the strategy. We’ll also use an exit that gets us out of the trade after 20 bars.
So, the rules become:
- Buy if the market closes at a 20 bar high
- Sell the position after 20 days.
Here is the resulting equity graph:
Mean Reversion VS Trend Following – Which is Best
Having covered both trading styles and their disadvantages and advantages, you may wonder which one you should go for. After all, both are highly popular trading methods that work well.
To be honest, there are two answers to this question, so let’s take them one by one:
1. It depends on you
Provided that you have a profitable trading strategy, either created by you yourself or bought from a reliable source, it all boils down to what type of trading you’re after and what suits your personality.
In short, you could say that you should choose trend following if:
- You want to trade a trading strategy that’s in the market for prolonged periods of time, and profits from those long swings
- You’re comfortable with placing relatively few trades and being wrong most of the time.
- You can cope with long drawdowns and placing trade after trade that ends in losses.
- You want a system that requires relatively little monitoring, but has great profit potential in the long run.
Instead, if the following feels more natural to you, you should probably go with mean reversion:
- You want to execute more trades, and be more active in the markets
- You like to be right, but understand that you’ll have to take some bigger hits now and then
- You can stand seeing a trade going against you, and still hold on to it, knowing that the edge is better now than when you entered.
While the points above, of course, aren’t definitive, they should at least provide some general guidance.
2. Combine both!
If you feel like both styles suit you, then there is no reason why you shouldn’t go for both mean reversion and trend following. By combining two trading styles that are so different, you’ll gain a lot of benefits in terms of diversification and risk control.
For instance, there will be times when trend following performs poorly while mean reversion flourishes. On the other hand, there will be times when the very opposite applies.
Thus, trading both mean reversion and trend following strategies will increase the odds that at least one part of your portfolio is invested in something that works well at the moment. This is a huge advantage that should not be underestimated. In fact, the ability to trade many strategies that rely on different logics simultaneously is one of the main reasons why we mostly trade algorithmically.
With the help of a computer, we execute up to 100 trading strategies at the same time, which allows for superior risk handling and diversification. If you haven’t checked out algorithmic trading yet, you definitely should!
Trend following and mean reversion both are great trading styles and come with their own sets of advantages and disadvantages. As such you really cannot go wrong with any of them and preferably should consider using them both to improve your overall trading performance.