Momentum and mean reversion are two opposing concepts when it comes to trading strategies and price movements in the financial markets. Here are the main differences between the two concepts:
- Momentum:
- Philosophy: Momentum is based on the idea that price movements in a certain direction tend to continue in that same direction for some time. If an asset has seen a price rise recently, a momentum-based strategy would bet on this rise continuing.
- Typical strategies: Traders using momentum strategies look to buy assets that have performed positively recently and sell or short those that have performed negatively.
- Underlying reasons: Momentum can be caused by a number of factors, such as investment flows, investors' behavioral reactions, or information gradually spreading through the market.
- Mean Reversion:
- Philosophy: Mean reversion is based on the idea that prices and returns tend to return to their average or "normal" level after periods of excess (whether upwards or downwards). If an asset has risen or fallen sharply, a mean-reversion strategy would bet on a return to a more "normal" value.
- Typical strategies: Traders adopting mean-reversion strategies will look to buy assets that have recently underperformed (assuming they are "undervalued") and sell or short assets that have recently outperformed (assuming they are "overvalued").
- Underlying reasons: Factors that may support mean reversion include excessive valuations, exaggerated emotional reactions by investors or inefficient market corrections.
These two concepts represent fundamentally different views of how prices evolve. While both momentum and mean-reversion strategies can be profitable, they require different market conditions, time horizons and risk management approaches.
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