Mean Reversion and Momentum Trading in the Financial Market

Mean reversion and momentum trading are the two dominating trading strategies used in the Forex and Stock Market. Most of trading strategy we can think of will fall under a category of mean reversion or momentum trading. These two trading strategies show completely different market timing. For example, momentum trading tries to take the entry when the price shows a strong directional movement. Momentum trading is often considered as the trend following strategy. On the other hand, mean reversion trading tries to take the entry when the price is far from the mean. Mean Reversion trading is often the core trading principle behind “Buy Low and Sell High” strategy like value investing. In momentum trading, the trader tries to pick trend whereas in the mean reversion trading, trader tries to pick the turning point.

Mean reversion and momentum trading

Figure 1-1: Conceptual drawing of mean reversion and momentum

Among the trading community, the preference between the mean reversion trading and momentum trading are completely different. Some trader uses the mean reversion trading better and some trader uses the momentum trading better. To find out which trading style you are good at with, you need to try both trading strategies. In fact, mean reversion and momentum trading can explain the water and fire elements of the human characteristics. Mean reversion trading explains the human characteristics of being “Cautious” or being “Realistic” like water. Momentum trading explains the human characteristics of “Impulsive behaviour” or “Heard Behaviour” like fire. However, the wise trader will not view these two trading strategy as two different subjects because one comes after the other. For example, mean reversion will come after momentum. Likewise, momentum will come after mean reversion. Therefore, the legendary trader like Jesse Livermore emphasized to observe the turning point, where the market shift its major direction. This does not mean that you have to trade against the large momentum in the financial market. This means that we need to buy the stock or currency as low price as possible near the turning point before another momentum is established. Once the momentum is established, it is not easy to ride on the momentum because the price move too fast. The heard or impulsive behaviour in the market can push the price in the shortest possible time. If you enter them too late, then you are likely to end up buying the stock or currency in high price. You will either make a thin profit or loss. For this reason, you need to find a way to enter the market between the turning point and the momentum. In doing so, you need to become familiar with the turning point as well as the trend. Therefore, you need to learn the methods of identifying the turning point and trend.

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