Trends or Reversals: What’s best to trade?

Updated: 5 days ago

How to decide which is the best Stock Trading Strategy for you.

Most positional traders and swing traders either specialize in trading trends or reversals. The most consistent and successful ones trade trends, although some legendary traders like George Soros and investors like Warren Buffet have also made a lot of their fortune looking for reversals.

My personal preference is 'trends' for singular stocks and 'reversals' for indexes and ETF's.

When Warren Buffet started investing as a business, he was a staunch Benjamin Graham follower. Warren would actively scout for opportunities that were mispriced, load on to them, and wait for them to reverse and deliver a handsome profit. It worked quite well for him given he became a multi-millionaire following that strategy.

Even now, he says he could deliver over a 50% per year compounded return, investing using the same strategy, if he had less capital to invest.

On the other hand, some investors and traders only invest in or trade trends and have built a fortune out of the same. Traders like Jim Rogers, Paul Tudor Jones, William O’ Niel, and Mark Minervini have had many years of consistent and successful track record of generating handsome returns with trend trading.

The Basics

So, what is the difference between these two forms of trading, and which one should you choose?

Trend trading is when you bet on the continuation of a move.

Traders mostly look for trends that are expected to last for varying lengths of time ranging from a week to a few years. The idea here is to look for continuation moves when the price is in a medium or long-term trend.

While trading trends, traders would have different systems to initiate the trades. These systems are designed to give entry signals either in pullbacks from the primary trend or towards a breakout when the continuation of the trend looks more probable.

My preference is a lateral consolidation on a weekly chart, this lateral movement provides rationale for a low risk stop loss. As such I developed a bespoke scanner just for my approach.

As a reversal trader, you would be on the lookout for oversold or overbought opportunities. Reversals are quite rewarding if you can maintain a decent win ratio and a favourable reward-risk.

However, reversal trading requires much more skillful execution than trend trading because markets trend most of the time, and reversal opportunities are far and few. But, one can build a fortune trading reversals only by getting a few trades right, whilst riding the winners while cutting the losers short when they are small.

The reversal approach is not something I would advise for singular stocks, its is often like catching a falling knife. Diversified funds yes, single stocks no.

Pros and Cons

There can be several ways to make money in trading and there is no one size fits all. Each form of trading has different benefits that suit the psychology of different kinds of traders. When it comes to choosing between the trend and reversal trading, it’s always “to each its own”.

Trend trading is relatively easy as markets trend most of the time and you will have ample opportunities to trade in all kinds of markets. Though rewarding if practiced rightly, it can also be an easy money guzzler if you don’t play by the rules and do not regard risk management.

Reversal trading, on the other hand, requires a lot of patience with very skillful execution for two reasons:

1) The opportunities are less than that in trend trading, and

2) The chances of errors are higher than that in trend trading, making risk management even more important.

Trends are easier to spot and trade than reversals and many traders are doing it successfully for years. The markets also haven’t changed much when it comes to trends, unlike reversal trading or value investing as it was called in earlier days, where opportunities are diminishing decade after decade.

Where do trend and reversal trading fit in human psychology?

When it comes to buying financial assets, the human mind is always programmed to buy low and sell high or vice versa. That’s not bad but it’s not as easy as it sounds and is also not always rewarding. While buying the dip may help newbies in strongly trending markets, there are often dips that don’t recover quickly. Some of them don’t come back at all (The singular stock issue).

At these points, uniformed and naïve traders keep buying lower and ultimately block their capital in duds (Opportunity cost). The markets then recover and move up without their stocks, as leaders of one bull market rarely lead the next.

Buying the dip profitably needs much more depth in analysis. It’s not as simple as buying a high-flying stock as soon as it cracks. That’s where the dumb money buys and smart money dumps. It’s certainly not a happy place to be.

Therefore, trading reversals has to be done with a clear strategy and robust risk management. One should not buy falling knives or short overshooting prices thinking that the price will reverse right when you put in the trade.

The concept of buying high and selling higher or selling low and buying even lower is alien to many but has been used successfully and consistently by many great investors. This approach provides better entry points and equally clear stop-loss points that removes a lot of subjectivity from trading. This counterintuitive approach to investing or trading also eliminates a lot of competition and makes you move in the direction of smart money.

The final word

There is a long learning curve in getting proficient in any form of trading, which is equally true for both trend and reversal trading. Whichever form you choose to trade, you will have to practice it for years together to be great at it. But once you have been through the grind, the money-making from trading almost goes on autopilot mode.

There will be many mistakes along the way, but the key is to not make irrecoverable mistakes, be open-minded and keep on working to be better at whatever form of trading you choose.

Learn rigorously about the two style of trading/investing and choose whichever style suits your trading objective, psychological makeup, and temperament.

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