Trading is a video game which consists of taking advantage of information asymmetries. It’s finding patterns in unstructured data, while simultaneously communicating a view of the world that summarizes how people make decisions.

There are two (basic) types of trading algorithms: trend following algorithms and trend reverting algorithms. Now you could make the argument that this is really only one type of trading algorithms, because you are following the trend of the trend reverting, but I am going to call it two.

Both trading algorithms demand that you are able to predict the future. The purpose of a trading algorithm is to find the fewest parameters needed to summarize reality. The classic information-compression paradigm. Trend following and trend reverting algorithms have opposing views on the way reality works.

Trend Following Algorithms

Trend following algorithms states that stocks will continue to move in directions that they are already moving. Apple has continued to succeed after all of these years. Buying and holding apple in the year 2000 is one of the best decisions that you could make. But obviously, being smart enough to buy AAPL in 2000 was very difficult because it was not obvious to know that AAPL would be the next big thing. You are also betting that the company will continue to outperform what it is currently worth due to some competitive advantage whether it be better ideas or better execution.

Trend following bets that the reason a company is outperforming the market is not due to luck. It is due to a competitive advantage that will allow continued outperformance. It is betting that the reason a company is doing so well is because they are more competent than the competition. That is a big bet because markets around stocks tend to be very efficient at sorting out competence. For any of the companies to make it to the top 100, it takes the ability to sort out competence from the less competent.

Trend Reverting Algorithms

Trend reverting algorithms is the belief that luck causes success. The only reason someone wins at the slot machines is due to luck. They just got lucky that one day. Most humans have the systematic bias of overestimating the ability that luck plays in life. We remember all the times that we are unlucky, but rarely remember the times that we are lucky. Not only do we not remember our luck, it’s rare that we even acknowledge our luck. Some of this is due to the fact that confidence is game theory optimal, but part of it is because we are only able to sample from the most likely probability distribution.