Traders spend countless hours agonizing over charts, pouring over data and analyzing their trades in the Herculean task of fitting the market into a tidy box in which their system will work. Trading systems generally do one of two things which are, as expected, diametrically opposed … jump on a trend or trade against it expecting reversion to the mean. Given that there is zero consensus on which side of this epic struggle is right, we can probably safely assume that neither side is “right,” or perhaps more interestingly…that both sides are right. Have you ever stared at a symbol that is “clearly” trading in a range, put on a position when it’s at the outer limits of that range, only for it to blow through you? Or wait for it to break out of a “range” for you to jump on the proverbial train only to have that train reverse and run you over? It’s not a question of whether the market trends or mean reverts…it will. It’s not a question of if your strategy works…it will. It’s more of a question of WHEN your strategy will work and when it will not…so don’t get too caught up on the strategy itself. IMHO, simple is best…again, most trading strategies can be titrated down to trending or mean reverting. That’s not to say that the trader who’s got 25 indicators is wrong, but in my experience more variables lead to more curve fitting. What’s a hapless primate to do?
When we trade, we expect (or more pessimistically, hope) that the market will move a certain way. Do you know the likelihood that it will move a certain way? If not, you can’t really determine a fair value for your trade. Take poker, for instance. Unless you’ve got the nuts, anything below 100% probability means that you can lose on any given hand. If you know your probabilities and constantly put yourself on the right side of the weighted coin, the law of large numbers dictates that over time, you’ll be a happy chimp.
That’s what we’re trying to accomplish here. We’re trying to provide a system by which you can gauge the likelihood of an event happening, namely reversion to the mean, how much confidence you can have in that happening, and in what timeframe. We are, by no means, implying anything about market participants, market events, sentiment, etc. What are ARE saying is that given a historical time series, we have an idea of how likely or unlikely something is to happening … and there are many ways to take advantage of that. How you do it is based upon your own personal circumstances and risk tolerances … for which we can only provide suggestions. If it’s not a question of “if” the market trends/mean reverts, but WHEN the market is trending/mean reverting, then it’s incumbent upon us to continually backtest and search for markets or assets which are currently behaving in predictable and definable ways. While these particular market conditions will inevitably break down or change, it’s our job as traders to steer our trading focus and capital allocation to assets/synthetics which offer the best opportunities. Some Wall St firms actually run competing strategies…both trend following and mean reversion. Both can be successful. Instead of focusing on the strategy itself, they focus on how much capital to allocate to each strategy given the current market conditions. Given the limitations imposed by our capital restrictions as retail traders, it’s even more important to use our capital efficiently. If you have a few potential setups, how do you determine how much capital to use on each? Do you have a rational, mathematically backed reason for your allocation? Quantitative measures such as confidence in reversion, size of current divergences, and time to reversion can help to rank your setups and determine how best to allocate your capital.
