Mean Reversion vs. Trend Following: Coke Vs. Pepsi

There are two kinds of traders in this world: the mean reversion crew and the trend followers. Both schools of thought have been battling it out on Wall Street for decades–two heavyweight boxers who refuse to retire. But which one is better? Well, that depends on who you ask—and the market’s mood on any given day.

Mean Reversion: The Rubber Band Effect

Mean reversion is built on a beautifully simple idea: what goes up must come down (and vice versa). It’s the trading equivalent of karma. The strategy is based on the notion that prices eventually return to their average or “mean” over time. Imagine a rubber band stretched too far in one direction; eventually, it snaps back. That’s the core principle here.

When It Works:
Mean reversion strategies tend to work best in range-bound markets—those periods where prices ping-pong between support and resistance levels. If a stock is trading well above its historical average, a mean reversion trader bets on it coming back down. If it’s below the average, they’re buying the dip.

When It Fails:
If the market is trending hard in one direction (think 2020 tech stocks or 2008 financials), mean reversion can chew up your capital like a ball player spitting whatever that stuff is on the mound. Betting on a reversal when the train has clearly left the station is a great way to lose your shirt. Sometimes prices don’t just revert. They just move on down the road.

Example Strategy: RSI Oversold/Overbought
One popular mean reversion indicator is the Relative Strength Index (RSI). I love the RSI. Because I’m a mean reversion guy. When RSI crosses above 70, a security is considered overbought, and mean reversion traders like me might short it (though I prefer 85 or 90, and shorter lengths than 14, but I digest). Conversely, an RSI below 30 (again, 15 if you’re me) signals an oversold condition, triggering a buy. It’s a straightforward approach, but it doesn’t always work, and risk management is everything.

Trend Following: The Momentum Junkie

Trend following is the polar opposite of mean reversion. Instead of betting on reversals, trend followers hitch a ride on momentum. If a stock is going up, they buy it. If it’s dropping like a rock, they short it. It’s less about predicting the future and more about riding the wave as long as it lasts.

When It Works:
Trend following shines in strong directional markets. Think about the Dot-com boom, the housing bubble, or more recently, the crypto surge. When prices are moving in a sustained trend, this strategy feels like printing money.

When It Fails:
Sideways markets are trend-following kryptonite. When prices chop back and forth without a clear direction, you’re in for a death by a thousand cuts. Getting whipsawed out of a position because a stock can’t decide where it wants to go suuucks…

Example Strategy: Moving Average Crossover
One of the simplest trend-following strategies involves moving average crossovers. When the short-term moving average crosses above the long-term moving average, it’s a buy signal. When it crosses below, it’s a sell. It’s like playing follow-the-leader with price action. Simple, but surprisingly effective in trending markets.

The Pros and Cons: Which One is Right for You?

Mean Reversion Pros:

• High Win Rate: Many small, consistent wins because prices often revert to the mean.
• Lower Drawdowns: Generally less volatile since trades are short-lived.

Mean Reversion Cons:

• Big Loss Potential: When it goes wrong, it can go really wrong. Risk management and stops are very important.
• Limited Gains: You’re always trading back to the mean. Gains are, by nature, limited.

Trend Following Pros:

• Unlimited Upside: In theory, you can ride a trend indefinitely. Just ask early Bitcoin investors. Or don’t. They are all insufferable geniuses.
• Low Maintenance: Set a target and let it go. Easy peasy.

Trend Following Cons:

• Low Win Rate: You’ll be wrong more often than you’re right. The key is to lose small and win big. Again, risk management, and psychology to a degree. Can you handle lots of losses if the gains are larger? Most can’t.
• Whipsaw Hell: Sideways markets are a death trap, leading to a series of small, frustrating losses.

Why Not Both?

Here’s a secret: the best traders often use both strategies depending on market conditions. Trend following works best in strong directional markets, while mean reversion thrives in range-bound conditions.

Hybrid Approach: The “Two-for-One Special”

One approach is to use mean reversion to enter a trade and trend following to exit. For example, if a stock is oversold, you buy in, but instead of selling when it gets back to the mean, you hold on and let the trend ride until momentum starts to fade. This allows you to capture the initial snapback and the subsequent trend continuation.

The reverse of this is called the “Double Kick to the Face” in which you try to reversal, and when it fails, hold the trade hoping for a reversal. You lose on the initial bet and then lose again holding on waiting for the rebound. Score!

Which Strategy is Better?

Honestly? Neither. It all depends on your personality, risk tolerance, and market conditions. If you’re the type who loves to fade the crowd and get a little ego boost in being right when everyone else was wrong, mean reversion is your game. If you prefer larger gains and a lower win rate and showing off your large trades and hiding your small losses on your new Discord group that’s only $39 per month, then trend following will suit you better.

Final Thoughts: It’s Not About Being Right; It’s About Making Money

At the end of the day, trading isn’t about being right all the time—it’s about making money. Both mean reversion and trend following can be highly profitable if executed with discipline and risk management. The key is knowing when to use each strategy. I personally am I reversal (mean reversion) trader. Don’t ask me why, I just like statistics. I read once that statistically speaking, we should have all died by now. But that’s also why I like statistics. Outliers are fun.

So which one should you choose? That’s like asking whether you should drink coffee or tea. The answer is simple. Drink coffee and use white tea, whatever that is, as the creamer.

One Last Tip: Don’t Be Dogmatic

The markets don’t care about your beliefs. They don’t care if you think a stock is “too high” or “too low.” They don’t care that your fib levels from 3 weeks ago are now exactly ⅓ of the way toward the fall equinox. They care about supply and demand. Period. In trading, stubbornness is expensive. Just ask anyone who shorted Tesla in 2020. Manage your risk accordingly, and don’t do stupid things.

For the record, today is the 8th down day in a row on Exxon Mobile (XOM). Statistically speaking, tomorrow should be up. Are you going to play trend follower, or do you think there’s enough gas in the tank (sorry) for a rally?