Quantitative Trading: Part 3 - Types of Systems

I began this series of posts with the intent of eventually explaining my personal style of trading and fundamental principles behind my trade decisions. If you are an old hat at system trading this post will be rather boring for you, but if you're new, it should be a decent addition to the introduction.

People classify quantitative trading into many categories or philosophies. In my mind there are TWO. Yep! Exactly TWO... at least when it comes to technical trading. I suppose if you start to mix in fundamentals you could argue that there are other types; but it could also be said that even fundamental analysts using quantitative assessments fall into one of these two categories. They are:

• Trending; and
• Mean Reversion

That's it. Put simply, either you believe that once a trend is in place it will continue, or you believe it will reverse. There are lots of names for these two things, but in the end most styles fit into one of these, or attempt to blend them in some way.

Trending:

Trend trading is known by many other names: Breakouts, Momentum, and others. Many traders are trend traders, but not necessarily quantitative traders. In fact, it's probably the most common discretionary trading approach in practice. The old axiom, "Keep your losses small and let your profits run" is very much a trend trading philosophy.

Perhaps the most publicized trend traders of all time, at least as a group, were the Turtle Traders. This was a group of traders taught by Richard Dennis to trade based on a breakout system that he and Bill Eckhardt developed. In short, they were taught to buy when a market made a new 20 day or 50 day high (I'm doing this from memory so you might want to check my facts on the system rules). I don't remember the whole system, but it was clearly a trend system.

Mebane Faber wrote a spectacular article on a quantitative trend trading approach that is absolutely worth reading. He provides a great analysis on how this method has performed over five different markets. In short, he recommends buying a market when the monthly close exceeds the 10 month moving average, and selling when it falls below. It's simple (most good systems are) and very effective. Not only does it outperform buy-and-hold in returns, but also in drawdown risk.

Trend trading systems are simple to understand. When a trend is established, the trader takes a position in the direction of the trend, believing it will continue. Quantitative trend trading has a very specific set of trading criteria, so specific that it can be easily backtested using Excel or other software.

Mean Reversion:

Mean reversion trading is equally simple. The philosophy, however, is almost opposite that of the trend trader. A mean reversion trader generally takes a position against the trend. Most likely they believe that the trend is over-extended... it's gone on too long, and is due for a reversal of some sort.

Mean reversion traders believe that the market stays generally close to it's average trading price over time; so, when it veers too far off that line, it's due to snap back to some degree. Generally speaking this is a short term trading approach, but it (like trend trading) can be traded in many time frames. Most of the mean reversion systems I've seen are swing trading systems and trades last just a few days.

I'll share more with you about mean reversion trading over the next few posts, but for now I'll just say that this is my preferred approach. I've not found many trend trading approaches that really work. Some appear to, like Faber's above, but I have yet to find one that will equal the risk adjusted return of a good mean reversion approach.

By the way, one of the common characteristics of a mean reversion system is that they generally do not "cut the losses short and let the winners run." That might seem odd, but that's my experience. Generally, my losses and wins are about the same size, but I have many more wins than losses. More on that to come.

Good Trading...