Typically involves the buying and selling of assets within shorter timeframes in order to capitalize from market fluctuations. It is often executed over hours or days - sometimes positions are even held for only minutes.
Focuses on purchasing assets with the expectation they will grow in value over longer time horizons - from weeks to years or longer. Depending on the exact holding period, investing tends to rely more on fundamental analysis and ignores short term price fluctuations.
The above image showcases the difference between trading and investing in action. An investor will purchase an asset which exhibits the determined criteria for future value accrual, and will hold the position for an entire, broad uptrend. While a trader will typically buy and sell within this broader move, attempting to profit from short term price inefficiencies. Neither method is right or wrong.
It may be easy to suggest that a trader would be more profitable - however it is important to note that this would only be correct if they were able to catch every single price movement, without losses. In practice, this is obviously incredibly difficult.
As such, the ‘most profitable method’ does not exist - a balanced approach, and a portfolio to match, utilizing both trading and long term investing principles is the ideal method.
This strategy assumes that existing price performance in a certain direction leads to a continuation of price action in that direction. This is based on multiple principles, such as the following.
Strong price momentum in either direction tends to attract more market participants. As price rises, it is human nature to experience the 'fear of missing out’ (FOMO). This can prompt investors to purchase the asset. Conversely, as prices fall panic selling can perpetuate the downtrend. This form of herd behavior is ingrained into the human psyche - leading to self reinforcing and repeating cycles that can significantly amplify trends.
The initial price movement can create a self-reinforcing feedback loop. As the price moves in a certain direction, it can trigger algorithmic trading systems designed to follow trends, further pushing the price in the original direction. These algorithms, which often incorporate aspects of market momentum into their decision-making processes, can significantly amplify price movements.
Although trend following often focuses on price action, the persistence of a strong trend can sometimes reflect changes in fundamental outlooks. Macroeconomic regimes (including debt/credit cycles), corporate fundamentals and supply/demand dynamics can all give rise to strong and persistent trends.
This strategy is based upon the assumption that there is always an inherent ‘fair value’ for an asset price - and any deviations above or below this will result in reversions back to the mean. The core mean reversion principles are as follows.
Mean reversion strategies often capitalize on the market's tendency to overreact to news - whether positive or negative. This can lead to excessive movements away from the historical average or ‘fair value’. This concept hinges on the assumption that once the initial overreaction subsides, prices will revert to their mean, allowing traders to profit from this adjustment.
Similar to trend following, mean reversion strategies also consider market psychology. However, in this context, the focus is on identifying when sentiment is at an extreme (either too bullish or too bearish) and is likely to revert back to a more neutral state.
It is important to note that each strategy is not timeframe specific - trends can arise on the 1 minute chart as well as spanning across years.
Mean reversion can occur on low timeframes when a larger position is sold at market value but is quickly absorbed. This is especially apparent on low-liquidity trading pairs and is characterized by long wicks above and below a more stationary trend or price level.
An example of a higher timeframe price overvaluation and subsequent correction (mean-reversion) would be the 2008 Global Financial Crisis. In this example the excessive valuation of mortgage-backed securities and real estate was eventually recognized by the market - leading to a sharp overcorrection as prices reverted to even below levels more reflective of their fundamental value.
This adjustment was not immediate but unfolded over several months as the underlying weaknesses in the financial system of the time were exposed. This demonstrates how mean reversion can occur on a higher, macroeconomic scale.
Here some examples of Indicators, which default into these categories. They can also switch between Mean Reversion and Trend Following modes, as desired by the Trader.
