Finding a Trading Approach That’s Right For You – Part 2

In Part 1 of this article we focused on the key trading objectives that we must quantify before beginning the search for the strategy that will match our personality and lifestyle. This month we’ll round off by looking at how we marry up those objectives with the right trading approach.

If our aim is to profit from market price movements, there are really only two types of strategy available to us; Trend Following, also known as momentum trading, and Mean Reversion, also known as swing trading. The two types of approach are quite different in their nature and it’s important to understand their differences, because our own objectives will tend to attract us to one type over the other.

Trend Following

With a trend following approach we are betting that the market price will continue to move in the same direction as it’s already trending. The market inefficiency that we aim to profit from is known as momentum and numerous academic studies have shown it to be something that can be profited from over the long term.

Momentum based systems tend to be medium to long term, aiming to stay in positions as long as the trend continues in your favour. This means the trades will have a longer average holding period. This longer holding period will tend to result in a higher expectancy per trade, but the system will also be exposed to more market risk due to the higher exposure it has. The risk in the system also means the win rate may only reach 50% or less. Meanwhile the trade frequency will be lower meaning there will be fewer orders to place.

This approach tends to appeal to those who want a low maintenance approach, and are willing to stomach a lower win rate and greater risk in return for a higher expectancy per trade.

Mean Reversion

The mean reversion, or swing trading approach, is looking for short term extremes in price and aiming to profit from the market reverting back towards the mean (hence the name). This is also a well-studied market inefficiency, with human emotion tending to push price far above or below its expected value until maximum pain is reached and the market reverses towards its normal range.

Mean reversion systems are shorter term in nature, only looking to hold for a few bars while the reversion takes place. This short holding period means the system is less exposed to market risk. These systems can also be more accurate with win rates in the 70%+ range. Their return per trade however, will tend to be smaller than momentum systems as they’re only trying to take a small “bite” out of the market each time. They can also have a higher trade frequency leading to more turnover of positions.

This type of approach will tend to appeal to traders who like a bit more action. Having low market exposure may also appeal to those who don’t like to carry a lot of open risk, with the compromise being a lower expectancy per trade. They can also be psychologically easier to trade than momentum systems due to the higher win rate available.

So in summary, if you select the strategy that fits with your own objectives, you’ll give yourself a much better chance of trading success than if you choose a strategy that goes against your personality and lifestyle. Of course, if you are able to trade both styles then that can have the advantage of smoothing out your returns over time, as the two approaches will tend to wax and wane at different times depending on market conditions.

Good luck in the search, and Happy Trading!