Systematic traders can be roughly divided into trend-followers and mean-reversion traders. The trend-followers look to exploit breakouts and breakdowns. The mean-reversion trader looks for patterns where the price bounces between clearly-defined supports and resistances.
The two trading methods are different. Both can be applied mechanically. The trend-follower sets a trailing stop-loss. He has no defined target. The mean-reversion trader has a defined target and, usually, a rigid stop-loss. For example, let us say a trend-following trader sees a breakout signal from a stock as it moves from say, 100 to 102. He sets a trailing stop-loss at 99 and goes long at 102. If the stock moves till 105, he moves the stop-loss up to 102. If the stock then moves till 108, he will move the stop to 105. He will repeat this process, so long as the uptrend lasts. When the uptrend fails, there will be an automatic exit as the stop is hit.
Now, let's say a mean-reversion trader believes a stock will bounce between support at 100 and resistance at 110. He will set a stop-loss at, say, 99 and go long, intending to exit or reverse at 110. He will not move the stop-loss while the price is between 100 and 110. If the trade is successful, he may book profits and short at 110, with a stop loss at, say, 111. Again, he will not move the stop-loss, until the 100-mark is hit and he exits the short trade.
One interesting point: It is possible to trade the same market successfully at the same time while using such different methods if traders are working in different time frames. The mean-reversion trader may see a "bouncing" pattern over a period of several months. The trend-follower may see a breakout over a period of weeks.
For example, the Nifty could be susceptible to both methods at the moment. The index has bounced from lows of 5,120 in last August. At some stage of the uptrend, it would have triggered a buy signal from different trend-following systems. As of now, the index is near 5,900. The trend-follower would be long, with a trailing stop-loss somewhere below at, say, 5,750.
At the same time, a mean-reversion trader may have noticed a more long-term pattern. The index has bounced several times from below 5,300 levels - so there is support at 5,250-5,300. The index has also hit a massive resistance above 6,000. This offers a broad trading range of 700-odd points. So the mean-reversion trader would also be long, with a stop-loss at 5,300 and the intention of reversing the trade at, say, 6,000. Both systems would be in the black. In this case, the trend-follower is working in a shorter time frame. His stop-losses will be closer to the current price. In other instances, the mean-reversion trader will be in the shorter time frame and his stops will be closer to the price.
The author is a technical and equity analyst
