Trend following vs. mean reversion

You can explain the logic of trend-following and mean-reversion approaches, name the market conditions each depends on, and summarize the research behind them.

Continue or snap back?

A price has risen steadily for weeks. One trader buys because it keeps rising. Another sells because it has risen too far, too fast.

Both have a reasonable logic, and both describe real behavior in markets. Almost every trading strategy belongs to one of these two families. Knowing which one you are using tells you in advance which markets will hurt you.

Buy strength, ride it

Trend following assumes that moves, once under way, tend to continue. Typical rules buy when the price breaks above a recent high or rises above a moving average, and sell or exit when the opposite happens.

In the fictional uptrend, the price rose from 101 to almost 121, and pullbacks mostly stayed above the 20-period exponential moving average. A trend follower who bought early and held would have captured much of the move.

The profile of trend following is typical:

many small losses, because many breakouts fail,
a few large gains, when a trend runs far,
long losing streaks in sideways markets.

Research supports a trend effect in many markets. Moskowitz, Ooi and Pedersen (2012) found time series momentum in 58 liquid futures and forward contracts: an instrument's return over the past 12 months tended to continue over the following months, before partly reversing over longer horizons.

Buy low, sell high in a range

Mean reversion assumes that prices that move far from an average tend to return toward it. Typical rules buy after a sharp fall or near the bottom of a range and sell near the top.

In the fictional range, the price turned down near 102.5 to 102.95 three times and turned up near 97 three times. A mean-reversion trader would buy near the range low, aim for the middle or the top, and place a stop below the range.

Its profile is the mirror image: frequent small gains, and occasional large losses when a range breaks and the price keeps going. Research has found reversal effects too, for example over one month for individual shares (Jegadeesh, 1990) and over three to five years for past winners and losers (De Bondt and Thaler, 1985).

Common mistakes

Mixing both logics in one rule. Buying a breakout and then hoping for a return is two strategies at once.
Judging a strategy in the wrong market. Trend rules look bad in ranges, mean-reversion rules in trends.
Removing the stop in mean reversion. "It will come back" is exactly the risk this approach carries.
Expecting smooth results. Both approaches have long periods that do not work.

The takeaway

Trend followers bet that moves continue, mean-reversion traders that they snap back. Each works in its own conditions and loses in the other's.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the zone where a mean-reversion trader would look for buying opportunities.

Tap the chart.

Near the range low, a mean-reversion trader expects the price to return toward the middle of the range, about 100.
2In which market does a trend-following rule usually lose money?

Trend followers buy strength and sell weakness. In a range, that means buying near the top and selling near the bottom.
3What did Moskowitz, Ooi and Pedersen (2012) find in futures markets?

They found the effect across 58 liquid futures and forwards, with reversals over longer horizons. Past results are no promise for the future.
4What is the main risk of a mean-reversion approach?

Mean reversion collects many small gains, but a breakout can produce one large loss. Stops matter most here.

of 4 correct.

Sources

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