When it comes to trading the stock market, most folks fall into one of two categories. There are “momentum” traders, and there are “reversion to the mean” traders.
Momentum trading involves finding stocks that are in strong trends (up or down) and then hopping aboard that trend. This is the “buy high – sell higher” philosophy. It works best when the market is in a strong, one-way trend. Trades tend to last for several weeks or months.
Most of the folks I know are momentum traders. But not me.
I fall into the “reversion to the mean” camp. In this camp, we look for extended conditions – where the proverbial rubber band is stretched just about as far as possible, and then we bet on a reversal and a snap back to normal conditions. This strategy works best when the market is choppy, and when there’s lots of back and forth action. Typical trades can last anywhere from a few hours to a few weeks.
Both strategies, momentum and reversion, can be enormously profitable when they’re right. When they’re wrong, though, it has been my experience that momentum traders suffer the most damage.
Momentum can change quickly. And when everyone is looking to get out of a popular trade all at the same time, it can be tough to exit a position at a reasonable price.
Reversion trades, on the other hand, are contrarian by nature. They’re unpopular. So, we don’t have to fight the crowds in order to get in or out of a position. And since the technical conditions of a reversion trade candidate are already quite stretched, any adverse moves are usually small and/or temporary.
For example, you may recall that a couple of months ago I wrote a bullish essay on retail stocks and a bearish essay on the semiconductor sector. I could not have picked two more contrarian trades. Retail stocks had been miserable performers for all of 2017 up until that point. And semiconductor stocks were super hot.
Both of those trade ideas were based on a reversion strategy. The retail sector had fallen too far. Semiconductor stocks had rallied too much. The rubber bands for those sectors were too stretched – retail to the downside and semiconductors to the upside. A snap-back move was inevitable.
Those trades went against me at first. But, as you can see in the charts below, the adverse moves were small and temporary…
In both cases, the rubber bands snapped back and produced profitable trades.
There’s no doubt that 2017 was a great year for momentum traders. The broad stock market was in an unrelenting uptrend. Any pullbacks that happened were relatively minor. And there wasn’t much volatility at all.
In that environment, momentum trading should outperform a reversion strategy. But my Delta Report subscribers still did pretty well anyway.
We made a total of about 76 trades. We profited on 61 of them – for a win rate of just over 80%. The average holding period was about one month. And the annualized return was well above 100%.
And we did all this in a low-volatility environment – which is usually a tough time for a reversion strategy.
Looking out into 2018, I expect we’ll do even better.
I don’t know for sure where the market is headed. I have my suspicions, of course. All I know for sure is that periods of low volatility in the stock market are always followed by periods of high volatility, and vice versa.
2017 was a low-volatility year. The Volatility Index (VIX) dipped below 10 multiple times. That’s an absurdly low level.
We’re likely to see an increase in volatility in 2018. The proverbial rubber bands are going to stretch farther in both directions. That means momentum traders are probably going to have a tougher time in 2018. And reversion traders are going to have many more opportunities to profit.
In tomorrow’s Market Minute, we’ll look at one of my favorite “rubber band” trading techniques.
Best regards and good trading,
P.S. Like I said, the market environment next year should be perfect for Delta Report subscribers.
And with my reversion trading strategy… along with earnings season right around the corner… well, let’s just say it’s an exciting time for my readers.
To learn a bit more about my strategy, and how effective it’ll be during the coming earnings season, click here.