All trading strategies can be divided into 2 basic types: contrarian and trend following. Both of these types can be divided into 2 subtypes: systematic (quantitative models) and discretionary (pattern recognition, Elliot Wave, discretionary reading of indicators, William O’Neill’s CANSLIM, etc). Hence, there are 4 subcategories of basic trading strategies:
- Systematic contrarian
- Systematic trend following
- Discretionary contrarian
- Discretionary trend following
These strategies uses fundamentals, technicals, and/or sentiment data.
What are contrarian strategies (systematic and discretionary)
Contrarian strategies try to predict the market’s bottom while it is falling and the market’s top while it is rising.
So anyone who tries to buy as the market falls and sell as the market rises is using a contrarian strategy. There are many different contrarian strategies. For example, you can try to catch tops and bottoms with
- Mean reversion (e.g. 20% above the 200 moving average, 20% below the 200 moving average).
- Reversal patterns such as head and shoulders, wedges, Gartley patterns, etc
- Momentum extremes (e.g. Relative Strength Index)
Contrarian strategies can be systematic or discretionary.
- A systematic contrarian strategy will use quantified indicators to consistently generate BUY and SELL signals.
- In addition, a trading model will have many components/indicators. Not all indicators will be bullish at the same time, and not all indicators will be bearish at the same time. In the event of a conflict (i.e. some indicators are bullish, others are bearish), the model has to state which indicator overrides the others.
- A discretionary contrarian trader will still look at the same indicators. The difference is that he will exercise human judgement as to whether or not he will follow the indicator’s advice. This is because no indicator is perfect. E.g. Sometimes the market bottoms when RSI hits 25, sometimes the market bottoms when RSI hits 15.
- In the event of a conflict between indicators, a discretionary trader will use human judgement to decide which indicator he should listen to.
What are trend following strategies (systematic and discretionary)
A trend following strategy employs a different logic than a contrarian strategy.
- Contrarian traders say “I think I can predict the bottom and top”.
- Trend followers say “trying to predict the exact bottom and top is dangerous. I’d rather wait for the market’s trend to be very clear and then make the easy profits”.
Trend following strategies are essentially breakout strategies. Trend followers will jump into the market when the market breaks out from a support or resistance because they think that a new trend has begun.
Trend followers are different from contrarian traders in another way:
- Contrarians say “the more oversold the market, the more I want to buy. The more overbought the market, the more I want to sell”.
- Trend followers say “there’s nothing wrong with buying on overbought momentum. The market often continues to soar when momentum is overbought, because overbought can become even more overbought”.
Both arguments have merit, and neither is wrong. Contrarian strategies work best when markets aren’t trending strongly. Trend following strategies work best during bubbles, which is why this is the best way to trade the cryptocurrency bubble.
Systematic trend following strategies typically involve something such as a moving average crossover (MACD) or a breakout above/below a moving average. Here’s an example of a very basic systematic trend following: buy when market rises above the 200 sma, sell when market falls below the 200 sma.
There’s no definitive answer as to which strategy is better. Trend following strategies can use technicals and fundamentals.
- Technicals (e.g. moving averages, trendlines) tell you if market is breaking out.
- Fundamentals can tell you whether a breakout is real or fake. If e.g. the S&P 500 breaks above the 200 sma, use fundamentals to confirm the breakout. if the S&P’s fundamentals are deteriorating, it’s probably a false breakout. If the fundamentals are improving, it’s probably a real breakout.
Sentiment data isn’t really used by trend followers. It’s mostly used as a contrarian indicator.
The best traders combine trend following strategies with contrarian strategies. Contrarian strategies are used to pick the tops and bottoms, while trend following strategies are used to confirm that there’s nothing wrong with your trade.
Pros and Cons that apply to all discretionary strategies
The market isn’t an exact science. It does not always follow a “if X, then Y” rule. Markets are a mixture of arts and sciences because markets are driven by human psychology. There are consistent patterns and also randomness in human pyschology.
With discretionary strategies, human traders can adjust their strategies as the market changes on a day-to-day basis. Quantitative models can’t capture a lot of one-time exogenous events, but humans can process these and think about a logical market conclusion. E.g. exogenous events like Brexit can be anticipated/reacted to by discretionary traders, but a quantitative model might not be able to anticipate these events.
More importantly, the global economy and financial markets are becoming increasingly complex. There are a lot of factors that you have to consider today that you didn’t have to consider before. A quantitative model might not adapt quickly enough to these new forces.
E.g. 20 years ago, who would’ve thought that Chinese demand would drive real estate markets in the world’s major cities?
There are macro forces that quantitative models cannot predict, but a human can if….
- He realized that China was a rapidly rising economy.
- He realized that rich Chinese people want to emigrate en masse to western countries.
- He realized that chinese people have a cultural affinity for real estate investments and speculation
There’s a lot of information that computers can’t capture and prioritize using numbers. Human traders can process this information without numbers.
Discretionary strategies have several key disadvantages.
The biggest problem is that you can’t backtest your trading strategy. The strategy will seem better in your head than in reality if you can’t backtest your trading strategy in an objective manner. So real-time performance may suffer significantly from what you expected.
For example, pattern recognition (using the human eye to spot continuation and reversal patterns) is a common discretionary strategy. But here’s the thing about pattern analysis:
- It “works” great in hindsight, but it’s not as perfect when you actually use it.
- Yes, every market reversal will have a “reversal pattern”.
- But when you’re actually using these patterns, you’ll realize that there are a lot of false signals. Some “reversal patterns” can turn into continuation patterns if the market continues its pre-existing trend!
Backtesting is important. It gives you an objective measure of how successful your trading / investing strategy would be. With a discretionary strategy, new traders don’t know if what they’re doing is correct unless they’ve already tried it out for many years.
Human psychology is another problem with discretionary trading. Let’s assume that you have a solid strategy. It can be hard to stick to your strategy. Warren Buffett’s saying “be greedy when others are fearful” sounds a lot easier than it actually is. We’re all human, and our thoughts will be influenced by other people. When everyone else thinks that a depression is imminent, it’s hard to be “greedy when others are fearful” That’s why very few long term investors bought stocks in March 2009. Many investors honestly became convinced that a depression was imminent.
A systematic, quantified strategy takes away the emotions and forces you to stick to the strategy. Believe it or not, your emotions can even impact strategies such as pattern analysis! If you’re fearful, you will see a lot of bullish reversal patterns as bearish continuation patterns. But you’re emotions cannot impacted by a pre-determined systematic strategy. The system is the system. It is emotionless, and it runs your trades based on a predetermined, objective set of rules.
Another disadvantage to discretionary trading is that it can get in the way of your life.
- You can’t trade if you’re sick. This is a problem that discretionary traders face. Illness or injuries can hurt their portfolios if they cannot monitor the markets.
- Discretionary trading needs to be put on hold if you’re on vacation.
- You need to be glued to the markets when you want to make a trade. You need to spend a lot of time thinking “should I buy or sell”?
Pros and Cons that apply to all systematic strategies
These pros and cons are essentially the opposite to the pros and cons that apply to all discretionary strategies.
The main advantage is that systematic trading strategies are very consistent. A systematic strategy takes the guesswork out of trading.
- You can backtest the results using as much historical data as possible. You don’t need to guess as to whether the strategy works or not.
- You don’t let emotions ruin your trading. I know traders who constantly second guess their strategy. It turns out that they will be much more profitable if they just stick to their strategy. A systematic strategy forces you to take every single trade that the model generates.
Here’s another big problem with discretionary strategies. A lot of times, the market will give you opposing signals. Some signals will be bullish while others will be bearish. Rarely will everything be bullish or everything be bearish. Every time one indicator conflicts with another, a discretionary trader has to decide which indicator should override the other.
With a systematic strategy, you can decide beforehand which indicator will overridden the others in the event of a conflict. In other words, you’re CONSISTENT with which factors are more/less important.
Systematic trading is also a lot easier for people who don’t trade full time. You can build a model, let the model trade, and update the model every once in a while. It’s not as time consuming. You can focus on your career and enjoy your life in the meantime. Discretionary trading is much more time consuming in the long run.
This is why I can travel the world and trade. My models are always running, even if I’m sleeping in Australia while it’s daytime in the U.S. No matter what happens to me, my models will always be trading.
Systematic trading can be extremely hard at first, and there’s a lot of information that you can’t express using numbers (e.g. exogenous events).
Exogenous events such as Brexit and the Trump election can significantly move markets in the short term. Nobody really expected Trump to win – he lagged too much in the polls. Hence a systematic and quantitative trading strategy would have discounted the possibility of a Trump victory.
In the event of an exogenous event like Trump’s election, a systematic trading strategy would trade as if the event did not exist. However, a discretionary trader can say “let’s close all of our positions today and wait for this election’s result. You never know. There might be a big market movement on this news”.
Pattern recognition using quantitative models is also extremely hard, unless you’re an expert in creating algorithms. For example, how do you quantify a “head and shoulders pattern”? No two real-life head and shoulders pattern look the same. Your algo has to be able to quantify a real head and shoulders pattern vs a fake head and shoulders pattern.
Pros and Cons that apply to all contrarian strategies
The advantages are simple. If you can catch the tops and bottoms with reasonable accuracy, then you can achieve massive profits! The initial leg of mean reversion is always the quickest and fiercest. Contrarian traders can earn massive instant profits.
In addition, the odds of you being being on the right side of the market are high. Mean reversion exists in everything: the weather, human history, etc. Good times follow bad times. Warm weather follows cold weather. Bull markets follow bear markets. The more extreme a market movement, the fiercer and bigger the eventual mean reversion.
You will have risk:reward on your side if you can calculate the risk correctly. Here’s an example.
- Let’s assume the market has crashed $100.
- You buy because the market is extremely oversold, and a bottom is imminent.
- You think the market will bounce AT LEAST $50.
- In the worst case scenario, you think the market will crash another $25 before bouncing.
- You have risk:reward on your side. Your risk is $25. Your reward is $50.
Although the odds of you being right are high, you might be too early. E.g. if you buy into a crash too early, your portfolio will be decimated. Yes, the market will eventually stage a rally. But what if it crashes too much in the meantime?
What if you calculated risk:reward wrong? What if the market crashes a lot more than you expected in the worst case scenario?
E.g. the market falls 50%. you buy because it’s insanely oversold. Then the market falls another 50%, before bouncing back 50%. you’re still down 25%
Nobody is perfect. Nobody can always predict tops and bottoms with perfect timing and $ entry points.
Contrarian strategies are more volatile than trend following strategies. Contrarian strategies can achieve massive profits, but can also suffer massive losses in a heartbeat.
Pros and Cons that apply to all trend following strategies
The advantages and disadvantages are almost opposite to that of contrarian strategies.
Trend followers will not be wiped out by a single massive loss. This is because trend followers always employ tight stop losses that prevent small losses from turning into big losses. Contrarian traders have no choice but to set very wide stop losses. By the time contrarian traders realize that their market outlook is wrong, it’s already too late. Their portfolio has already suffered a massive loss.
Trend following works extremely well during bubbles (e.g. the cryptocurrency bubble). Corrections during bubbles tend to be very large, so contrarian traders will use smaller position sizes. They need to average-in during corrections. Their small position sizes shrink their performance. Trend followers can use larger position sizes with tight stop losses once a trend has begun. Their large position sizes will maximize profits during a bubble.
Markets that trend strongly can remain insanely overbought/oversold for a very long time. This market stage will kill contrarian traders, but will yield massive profits for trend followers.
Ultimately, the big money is in the trend. That’s where the saying “it’s a bull market ya know” came from. Instead of trying to “catch the falling knife” and potentially being killed by it, trend followers wait until the reversal has occurred and the new trend is more assured.
Trend following’s main disadvantage is that it doesn’t work when the market swings sideways. Contrarian strategies work best when the market is swinging sideways or when the market is very choppy.
When the market swings sideways or is choppy, trend followers accumulate a lot of small losses. These losses add up overtime, which is the proverbial “death by a thousand cuts”.
In addition, there are a lot of false breakouts. These false breakouts will result in many small losses for trend followers.