Objective

Short-term overreactions are abundant in liquid equity indexes. Overreactions are caused by the propensity of investors to buy high and sell low and typically manifest as pockets of choppy, back and forth price action as a market swings from an overreaction extreme back to more “normal” trading levels.

The objective of our counter-trend models is to trade in the direction of "smart money". Our models take advantage of short-term price movements by trading in the opposite direction of an overreaction; going long after a decline and short after an increase (buy low, sell high). This allows the models to capitalize on the natural mean reversion of prices after an overreaction.

Thesis

At the most fundamental level, counter-trend models exploit the repeatable price patterns caused by short-term cycles of fear and greed in equity markets.

Our counter-trend thesis can be broken into three parts:

• Shocks from news events cause market participants to overreact (too fearful or too exuberant) which leads to short-term price dislocations.
• As a whole, the market is efficient at recognizing these dislocations. Therefore, prices often mean-revert within a day or two.
• Abundant news flow and efficient trading increase the frequency of short-term overreactions. They also shorten the time it takes for overreactions to be corrected.

Sample Illustration

What to Expect

Regardless of the exact composition of a counter-trend system, these strategies have a common statistical signature. They produce short duration trades, often with an average holding period of only two or three days. They typically generate a high percentage of winning trades, usually between 60% and 70%. Finally, in an uptrend, these models have a slight short bias, and in a downtrend, they tend to have a slight long bias. Overall, these models are fairly neutral with respect to direction when considering a full 5 to 10-year market cycle, offering significant diversification to a long only equity portfolio.

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