Trend Trades vs Mean Reversion Trades

11:47 am - August 5, 2011

I forget who first expressed the idea — want to say Gavekal — that there are only three types of trade:

Trend
Mean Reversion
Carry

Trend trades tend to bet on breakouts (in either direction) and forward momentum to persist.

Mean reversion, in contrast, is about finding stretched rubber bands and expecting them to snap back.

And carry trades are all about collecting yield — swapping a low-yielding instrument (like cash or borrowed yen) for a higher yielding one.

The distinction can get messy because a lot of mean reversion players operate within trends, and carry trades tend to exploit prevailing trends.

But on a broader philosophical level, the trending style is more oriented to outliers and fat tails — profiting from non-normal events — whereas mean reversion is about “normal” or “business as usual” type movements in the market.

There are big implications here, in terms of both psychology and P&L:

Strong trend moves tend to be outliers. They happen less often, but pay off big when they do happen. Frequency is low, but expectation is high.

Mean reverting movements — the rubber band snapping back — tend to be common. They happen a lot, but exploitation gains are small. Frequency is high, but expectation is low.

With the trend orientation — low frequency and higher expectation — you get bigger payoffs on a “lumpy,” less predictable basis. (This dovetails with the observation that markets obey power laws.)

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With the mean reversion orientation — high frequency and lower expectation — you get satisfaction on a far more predictable basis, but it comes in much smaller bites (and bears heavy transaction costs).

Truly versatile traders have access to all styles. Yet in our opinion, the trend orientation is superior because mother nature favors it. The big money is in the outliers, because of the way profit opportunities are naturally distributed by the market — not evenly, but in concentrated bursts for limited periods of time.

In otherwords: If you can catch a handful of major moves per year and not get ground up in subsequent chop, long-run performance will be powerful. Periods of light activity are essential to this strategy. (As an extreme mental example, just think of the multi-year periods where straight up t-bill returns trounced the S&P.)

As testified to by Ken Grant, the author of Trading Risk, there is a reason why the biggest and best traders in the world typically have a 90 /10 P&L ratio (90% of total profits coming from 10% of trades).

That kind of profile dovetails with an outlier focus (and is naturally expressed in the “Selectivity and Spread” concept).

Also: If you’ve played a reasonable amount of cash game poker, you know the outlier sessions where you win big — maybe 1 out of 10 — provide the bulk of bankable gains at the end of the year. The other sessions are important too, but mainly in the context of jockeying for position (and maintaining risk control).

In trading, in poker — heck, in business and love and life in general too — it’s the well-timed big move that generates the big payoff. As usual, Jesse Livermore had it right (via Reminiscences):

“And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine – that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.”