Every trading position is based upon assumptions of momentum or reversion. A momentum strategy assumes that once a trend is established, it will continue indefinitely. A reversion strategy assumes range-trading will occur, with prices bouncing between resistances and supports.
The details are built around the first assumption. A momentum system sets trailing stops and does not have clearly defined targets. If the price moves into profit, the initial stop-loss is moved closer to the new price. The trade might be rolled over indefinitely, until and unless the trailing stop is hit.
A reversion strategy usually sets a fixed stop and has price targets. When the target is hit, the strategy recommends taking the reverse trade. Reversion systems might involve a series of reversed trades that continue until and unless a stop is triggered, implying the range-trading has ended.
Identification methods are also different. For example, a momentum trader seeks a new high or low in a given timeframe. Some might consider a 20-day high (low) significant; others could look for a 55-day high or a 200-day, or 52-week high. Once the new high or low is established, a momentum trader assumes the price will continue to move in the same direction.
A reversion trader will look for prices close to significant highs or lows. For example, a reversion trade may be triggered if the price is, say, two per cent below a 20-day high, or two per cent above a 20-day low. The reversion trader assumes the price will soon move in the opposite direction by bouncing off the high or low. Reversion trades use highs and lows as stop losses or sometimes, they set the stop at say, two-three per cent above a high (two-three per cent below a low).
Most traders display some sort of bias in that they favour one or the other strategy. Statistical analysis suggests reversions are more likely to work in a given timeframe but momentum offers higher returns when it does work.
One practical problem is that ideally, the trader needs to go short or long with equal facility to gain the maximum benefit. This isn't possible with stocks. Borrowing a stock for a short adds to the costs of the trade at the minimum. In India, borrowing is quite difficult anyway.
A long-only use of either a momentum or reversion strategy is less profitable. In a bear market, where more shares are going down than up, it is often difficult to implement and risky. Hence, these trading strategies are often focused on derivatives - stock and index futures, or commodity futures or currencies. All these are highly leveraged contracts and leverage magnifies losses and gains.
One of the odder things is that the same contract may have momentum and reversion character at the same time, in different timeframes. For example, a stock could have a long-term reversion pattern where it is range-trading between long-term support and resistance. It will have a momentum pattern in shorter timeframes as it rises off the long-term support and then again as it falls from the long-term resistance.
There may also be a situation where a contract has a long-term momentum pattern and a short-term range trading pattern. This occurs when there's a breakout, following by a reversion-consolidation move, followed by another breakout, etc.
In such cases, traders will play the short-term pattern, while others focus on the long term. You may even, in certain cases, have the same trader playing both patterns, using different strategies to run two trades at the same time. The Nifty for instance, has range-traded for the past 12 months, moving between 5,500 and 6,100, with occasional abortive breakouts (52-week high of 6,229) and breakdowns (52-week low of 5,119). It has seen multiple momentum phases within this period, with short-term swings of 500 points or more in either direction.
At the current value of 6,096, it is close to the top of this trading zone. Reversion systems would suggest going short with stop, losses set at above 6,230. A short-term momentum system would be long. Which way should one lean? My bet would be on reversion.
