Most of us understand buying low and selling high is a way to make money. In order to do that, you must be able to make a correct judgement on the direction of the asset that you are buying. You lose money when the asset price goes in the opposite direction of your anticipation.
Besides the usual directional strategy, there are other non-directional methods that traders and hedge funds employ to profit from the market. There are many terms to describe such methods but I will just say that they are all anticipating a convergence in prices or a reversion to the mean.
We learn statistics whereby the mean is the average of a series of numbers. For example, you have 10 days of prices of the same stock; you get the average price for the 10 days by dividing the sum of prices by 10. This is what we do with moving averages. In directional methods, you can employ moving averages as an indication that price is moving up when the price crosses the average. When you go directional, you are hoping the price would diverge from the mean price. In non-directional sense, you believe the price will revert to the mean eventually as it cannot diverge for too long. You are expecting the prices to converge per se.
For non-directional strategy, you require 2 positions to remove the bias towards a particular direction. For example, stock A and stock B have high correlation based on history, especially since they are in the same industry. When stock A moves up but stock B does not, you would short stock A and buy stock B, hoping A will fall and B would rise.
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
Who is right? I believe it depends on the timeframe. Prices tend to converge during short period of time and prices tend to diverge over long period of time. Put it this way hypothetically, Google and Yahoo area both in the IT industry and very much similar in their business model. Their stock prices should move in tandem day to day, or even minutes to minutes. Overtime, as Google grow and take more market share from Yahoo, Google stock price should go up and Yahoo stock price should go down. In other words, the strategies you adopt is very much dependent on the timeframe.
Today’s high frequency trading and algorithm trading are exploiting such small and minute inefficiencies over a short period of time to profit from the market. Professional traders and scalpers also engaged in similar short term convergence trades. Statistically, market does not move most of the time and hence, convergence strategies are morre reliable. On the other hand, directional strategies require more patience waiting for the trend to form. This is why investing takes a long time to realize gains.