Counter Trend Trading Strategy
You may have heard the traders’ expression ‘Let the trend be your friend’, which means you should, by and large, trade with the trend. So it appears contradictory to talk about counter trend trading strategies. Still, it becomes a little easier to understand when you call them by a more common name, trend reversal strategies.
Counter trend trading strategies are strategies that look for a trend that is going to reverse, and seek to profit by trading early in the reversal pattern. Some traders regard them as more risky than trend trading, but your risk is mitigated by determining what cues or signals you will use to detect that the trend is switching. Certainly if you can be early in betting correctly on a trend reversal, you stand to maximize your gain.
As with all trading, you should have a clear plan or strategy before you start, quantifying the events or values that will trigger your entry and exit positions. The exit is particularly pertinent with trend reversal strategies, as you are betting that a trend is going to discontinue and turn around. You need to close your position quickly in order to minimize your losses if the trend instead keeps going.
There are several technical analysis and charting techniques that can point you to a financial instrument that is about to reverse. On the graphical side, you can look for shorter bodied candlesticks, perhaps a doji, showing that there is indecision in the market and a possibility that trader sentiment is changing. But quantifying a signal for trade entry is perhaps best done by technical analysis using indicators such as the Moving Average Convergence/Divergence Oscillator (MACD), or the Relative Strength Index (RSI).
Most technical indicators are useful for determining overbought and oversold conditions, although the fact that the indicator goes to the extreme does not mean that the trend is necessarily ending immediately. However, depending on the indicator, when the value comes back from the extreme and crosses a certain threshold it may be taken as an indication of a trend change.
For example, the RSI usually indicates overbought when the value is above 70, and oversold if below 30. In practice, the indicator can move above or below these levels while a trend is continuing strongly. But if you see a divergence in direction between the price and the indicator, it is usually a sign that something about to happen. Other traders will wait until the indicator crosses the middle line before acting.
As an alternative, some indicators like the MACD also have a signal line, which when it crosses the MACD line gives a clear point at which to take trading action. Whichever system you want to try, you should backtest it first on the financial instrument you want to trade, and see what works best.
As mentioned, with counter trend strategies you need to be extra careful to guard against the possibility that you have “jumped the gun” and opened a trade when the market was merely faking a change in direction. This is bound to happen from time to time, no matter how you work to perfect your strategy – there is always unpredictability in the markets that cannot be accounted for.
So before you take out your bet, and well before you become emotionally attached to it (which can cloud your judgement), you need to set a limit to how far you will let the market go against you before you decide the spread bet is not working. This is essential in any case, as you need to calculate the position at which you exit a losing trade so that you can calculate the size of the spread bet.
If you can identify a historic level at which the market has reversed before, a support or resistance level, then you can set your exit point just outside it. Bear in mind that, in this context, both support and resistance levels are equally valid and usable, regardless of the current trend direction. Use them to help you plan the trade.
Finally, the exit that you are hoping for, a winning exit. If the trend reverses as you have anticipated, there may or may not be a basis for setting a target level. You can safeguard your gains by using a trailing stop exit strategy, in the absence of any other indication of when the counter trend move may be failing.
Counter trend trading strategies can be very profitable, as you start profiting before the trend traders enter the market. But you have to watch carefully, particularly at the start, to make sure that your bet works out.
