Trend Following & Mean

Reverting Indicators:
How to Use, When to
Use, and How to Use
Together

WILL GEISDORF, CMT

January 7, 2015
Please see important disclosures at the end of this report. www.ndr.com | Periodical
Rule #1 at Ned Davis
Research
 Don’t Fight the Tape!

“The Trend is Your Friend”

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“I always come back to trend-following indicators because if a big move is coming, they pretty much
guarantee losses will be cut short and profits can run. In other words, they have a built-in stop-loss.”
-Ned Davis (Institutional Hotline, 2/13/2012)

Simple trend-
following
strategy

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 The word “whipsaw” comes from the timber industry where a long, thin, two-man wood saw would often
get caught in a log, if not properly handled, and whip the sawyers back and forth without cutting the wood
and subjecting them to “two damaging and usually opposing forces at the same time”.

Simple trend-following
strategy failed in secular bear
of the 1970s

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What to do when there
isn’t a trend to befriend?
Use the following types of indicators:

 Oscillators

 Mean-Reverting Indicators

 Overbought/Oversold Indicators

 Sentiment

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Mean-reverting indicators tend to have a high percentage of profitable trades. However, in a trending
market they oftentimes let losses run and cut profits short.

A lot of winning trades

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In a directionless market, like the 1970s secular bear, mean-reverting indicators tend to outperform trend-
following systems.

A lot of winning trades

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Combing Trend-Following
& Mean-Reverting
Indicators
Adaptive Trading Model

 Stand alone Trend-Following Model

 Stand alone Mean-Reverting Model

 Strength of Trend Composite to determine whether the

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 Strength of Trend Concept #1
Welles Wilder’s Average Directional Index was created to measure trend strength without regard to trend
direction.

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 Strength of Trend Concept #2
Efficiency ratio was developed by Perry Kaufman as a way of measuring noise in the market. It compares the absolute
change in price over a set period to the sum of the absolute daily changes over the same period.

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 Strength of Trend Concept #3
A correlation coefficient value (r2) is the result of measuring the residuals of a linear regression. When
the linear regression fit is strong, r2 will be near 1, indicating a trending market. When the linear
regression fit is weak, r2 will be near 0, indicating a directionless market.

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 Strength of Trend Concept #4
A bandpass is an adjective that describes a type of filter or filtering process. John Ehlers and Ric Way apply the idea of a
bandpass filter to equity markets in the March 2010 issue of Technical Analysis of STOCKS & COMMODITIES. They
empirically decompose market data into a cycle component and a trend component.

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Strength of Trend Composite is a diffusion model based on signals from ADX, Efficiency Ratio, R2, and
Bandpass Filter indicators.

Majority of
indicators
trending

Majority of
indicators mean-
reverting

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Signal from Strength of Trend Composite determines whether the model follows the message from our
trend-following or mean-reverting model.

Strength of Trend
Composite

Trend-Following Mean-Reverting
Model Model

Bullish Bearish Bullish Neutral Bearish

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Trend-Following Model

 Point & Figure

 Adaptive Moving Average

 Triple Exponential Moving Average

 True Strength Index

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 Trend-Following Concept #1
Simple Point & Figure Trading Strategy

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 Trend-Following Concept #2
Adaptive moving average is based on the concept that a noisy market requires a slower trend than a quiet
market. This means the trendline should lag further behind a noisy market to avoid whipsaws.

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 Trend-Following Concept #3
Changes in a moving average can be abrupt based on the size of the values entering and leaving the
period being smoothed. Applying a smoothing three times increases importance on the middle values.

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 Trend-Following Concept #4
The True Strength Index (TSI) is based on a smoothed one-period rate of change. William Blau referred to
this concept as using momentum as a more sensitive proxy for price.

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 Trend-Following Model is a diffusion index based on the four indicators just discussed.

Majority of trend-following
indicators bullish

Majority of trend-following
indicators bearish

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Mean-Reverting Model

 Overbought/Oversold

 Bullish & Bearish Divergence

 Excessive Optimism/Pessimism

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 Mean-Reverting Concept #1
Calculate the % of stocks trading below lower Bollinger Band. Identify when the % is at an extreme. Look
for reversal from extreme level to generate a short-term buy signal.

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 Mean-Reverting Concept #2
Calculate the % of stocks on sell signals using a very sensitive P&F rule. Identify when the % reaches an
extreme. Look for reversal from extreme level to generate short-term buy signal.

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 Mean-Reverting Concept #3
My attempt to quantify divergences between price and momentum.

Bullish
Divergence

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 Calculate slope of two-month regressions for price and 30-day momentum.
Normalize slope readings by calculating 30-day stochastic of each. Compare stochastic readings.

Bullish Divergence

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 Mean-Reverting Concept #4
SKEW measures perceived tail risk, comparing the price OTM puts relative to OTM calls. Large declines in SKEW signal
complacency. Look for reversals from extreme complacency to trigger short-term sell signals.

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 Mean-Reverting Concept #5
Short-term changes in VIX can be used as a sentiment measure. A large short-term increase in VIX is a
sign that implied volatility is increasing. This indicates pessimism/fear amongst investors.

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Mean-Reverting Model a diffusion of five concepts and 10 total indicators.
Five indicators produce buy or neutral signals.
Five indicators produce sell or neutral signals.

Market reversing from

Market reversing from

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 Current State of the Model
Trend-Following Model is bullish. Mean-Reverting Model is neutral.
Strength of Trend Composite signaling a mean-reverting environment. Model is neutral.

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Model has outperformed Buy/Hold over past five years with less risk.

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SUMMARY
 Trend-Following & Mean-Reverting indicators are both
valuable tools for investors

 Several technical tools available to help identify

 Adaptive Trading Model tries to incorporate both types

Potential Model Enhancement:

 Improve optimization technique used to choose

 Look for additional indicators to help determine market

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Shameless Plug
 Buy the latest edition of “Being Right or Making Money”

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