Mean reversion vs momentum

What it is

Almost every strategy is one of two kinds. Momentum (trend following, breakouts) bets that a move will continue: buy strength, sell weakness. Mean reversion (range trading, fading extremes) bets that a stretched move will snap back towards an average: buy weakness, sell strength.

They work in opposite conditions. Momentum does well in trends and loses in ranges; mean reversion does the reverse. The market's 'regime' (trending or ranging, calm or volatile) decides which is in favour, and it changes over time.

How to spot it

• Trend regime: rising ADX, price staying on one side of its moving averages, value areas moving one way.
• Range regime: low ADX, overlapping value, price rotating around VWAP.

How to use it

• Know which kind your strategy is, and add a regime filter (ADX, the position of price relative to a moving average or value area).
• In the backtester, compare results in trending and ranging periods separately.

Common mistakes

• Running a breakout strategy in a quiet range and a fade strategy in a trend.
• Switching styles after every losing streak.

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