Learnt the terrible lesson, lost all today, need to take a step back and do extensive reading: momentum vs mean-reversion
- Jim argued noise/information is way too much, so over short to medium-term, mean reverson must work
- Some interesting comments on trend following:
- Academic work by Titman, Sarno etc.
- Market Wizards
- Well I don't think
anyone has a silver bullet for when/where trend-following vs
mean-reverting works. At least if they did they should be sipping
margaritas on a yacht in the Riviera. Here though is how I think about
it. Auto-correlation whether positive or negative is a function of two
things. The first is order flow persistence, i.e. it's a well known fact
that if there are more buys than sells in one period, than one would
expect all things being equal more buys than sells in the next period.
The second is order flow elasticity, i.e. as the price rises there will
be fewer buyers and more sellers and vice versa. The former is the logic
behind trend-following. The latter is why that logic doesn't always
hold, if there was heavy buying action that pushed the price up it might
dry up buyers and flood sellers in the next period pushing the price
down.
I think this paradigm goes a long way towards explaining
why trend-following works in certain markets and mean-reversion works in
others. For example take one of the most well-known mean-reverting
markets, the idiosyncratic return component of equities (i.e. the
returns of single stocks neutralized against the major market factors).
This formed the core of many stat-arb strategies for a very long time.
And with very good reason, one would expect order flow to be highly
elastic for idiosyncratic equity factors. Most equities outside of their
core factor exposures are very close substitutes for each other. So
investors have very little tolerance if the idiosyncratic returns drive
prices away from fair value. E.g. if the idiosyncratic component of one
firm in the S&P 500 was higher than the others most investors would
substitute to the others very easily.
In contrast one of the best
markets for trend-following tends to be commodities. And with good
reason, the buyers and sellers are very price inelastic. For example if
the price of oil goes up, consumers can't quickly substitute away from
using crude oil. There are massive infrastructure changes that need to
be made. Similar if say wheat is falling, it's not like farmers can
easily switch over to growing corn without making large capital
expenditures. So low elasticity leads to momentum, because when there's
an imbalance between buyers and sellers it takes longer for prices to
readjust to a point to bring markets back to equilibrium.
- LowVol, Down Market: Just punt
LowVol, Up Market: MOM performs well
HighVol, Down Market: MR performs well
HighVol, Up Market: MOM & MR performs okay
- Keep reading and I'll reach my own conclusion
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