Mean Reversion Strategies: Is Short Term Trading Too Risky?

Every now and then I get an e-mail from someone who has come across one of our articles on short-term trading in stocks and ETF who is concerned that our approach to trading – or short term trading in general – is too “risky” for the average person. To some readers, discussions about short term trading strategies should be accompanied with the sort of warnings we see affixed to heavy machinery or electrical equipment.

To be sure, short term trading in stocks and ETFs is not for kids. But is short term trading inherently any “riskier” than, say, buy and hold investing in the Age of Enron, Bear Stearns, Lehman Brothers, AIG …?

Our approach to short term trading is not without risk – no business, no opportunity to make money is without some measure of risk. What is important, the difference between ventures that are “too risky” and those that have a reasonable balance between risk and reward, is in part the degree to which the person – in this case the trader – understands the potential risks involved and what is needed to mitigate those risks.

For example, our short term trading strategies for both stocks and ETFs involve buying low and selling high, buying markets when they are on sale and selling them when buyers are pounding on the counters, demanding to be served at any price.

To many, this appears to be a risky approach to trading. While other short term traders typically wait for stocks and ETFs to reach new highs before buying, we instead look to buy stocks and ETFs when they make new lows. Why? Because the research we have conducted on short term stock price behavior – going back to 1995 – is clear and consistent on this point: in the short term, stocks and ETFs that make short term lows tend to outperform stocks and ETFs that make short term highs.

We have even created a number of high probability trading strategies – such as the Double 7s Strategy for ETFs – based on these discoveries.

Our approach to short term trading seems risky to some not because it is any more risky than other short term trading strategy – if anything, our quantified, backtested results argue the opposite. But because our strategies are counter-intuitive, buying when the rest of the trading world is nervous, afraid and panicking, they often appear “too risky” to many people.

Again, not every trade will make money. And there is more to controlling risk in a trade than buying low and selling high (though this is a very good first step if you are trading stocks or ETFs in the short term). Position-sizing, for example, is another tool that short term traders can use to manage risk. Trading ETFs rather than stocks also eliminates another form of risk – corporate or single stock risk – that can cause trouble for traders in some instances.

But when deciding whether a trading strategy is “too risky,” traders should be careful to separate the reality of risk (i.e., occasional losses – though many more winners – with high probability, mean reversion trading strategies) from the fear or appearance of risk (i.e., a generalized fear of buying markets as they move lower, even if they are becoming cheaper).

Even if a given trading strategy does not fit your personality – and not everyone is comfortable with high probability mean reversion trading strategies – that does not necessarily make it any more “risky” than another trading strategy – including so-called buy and hold investing.

Learn How to Trade ETFs! Click here to find out more information about our upcoming High Probability ETF Trading seminar this Thursday led by TradingMarkets founder and CEO, Larry Connors!