Under what market conditions does mean-reversion work better than trend-following?


Here is an excellent article written by Laurent Bernut, the CEO of Alpha Security Capital

The article describes the pitfalls of both trend following and mean reversion trading strategies along with ample insight into developing a trading system using the so-called Common Sense Ratio.

Finance is one industry where there is no shortage of creativity. There is always a new strategy, investment vehicle, or asset class. This alphabet soup is confusing, particularly when it comes to assessing risk and reward across asset classes. Yet, there is a simple universal way to classify strategies. They fall into two buckets: either mean reversion or trend following. Simply said, the exit policy determines the win rate, which then shapes the return distribution.

Trend following strategies rely on the capital appreciation of a few big winners. Whether they follow stories, fundamentals, earnings or price momentum, stock pickers are trend followers. They may fail to appreciate being called trend followers, but their P&L distribution tells a different story.

Summary

  • Regardless of the asset class, there are only two types of strategies: mean reversion or trend following
  • Each strategy type has a specific risk profile, which require different risk metrics. Common Sense Ratio recaptures risk for all strategy types (Read this, it is important)
  • How to increase the win rate, gain expectancy and overall profitability depending on strategy type ?

I. The only two types of strategies: mean reversion or trend following

Over the years of patiently testing multiple algorithmic strategies, patterns in the return distribution repeated over and over. It eventually became apparent that strategies fall into two buckets: mean reversion or trend following. Attached are graphical representations of the gain expectancy of mean reversion and trend following strategies. The reason why the same patterns repeat themselves is simple: exit policy.

Read the rest of the article at https://goo.gl/p8nmcH

About Praveen Pious Francis
A part-time blogger who has a wide range of interests including investing in the stock markets across the globe and broadband technologies in India. If you feel that this post has helped improve your daily trading activities, please consider donating to my PayPal praveenpious@live.com. Donations encourage me to keep on researching newer day trading strategies.

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