The vast majority of strategies promoted on market forums and trading blogs are focused on trend-following strategies. There is less information on trading strategies based on countertrend approaches.
So, we decided to change a few things. In this guide, we are going to give you an idea of countertrend moves and how you can trade with them specific to our markets.
What is a countertrend?
A countertrend strategy is a trading tactic that seeks to earn small profits by trading against the current trend. Traders also call this strategy countertrend trading. The strategy seeks to profit from price corrections in trending security. Contrarian traders are those that trade against the trend.
Countertrend trading strategies are often used by contrarian traders. The strategy entails buying/selling security after an impulsive bearish/bullish move in the hope that a corrective move higher/lower would enable them to sell/buy it back at that higher/lower price.
In this case, the buy low, sell high paradigm is satisfied, and the trader’s account benefits.
Traders that use this strategy make smaller profits and are prepared to exit if the predicted correction does not occur.
A countertrend strategy disregards the common investing theory that the trend is your friend, at least for the time being. Countertrend strategies employ momentum measures, reversal trends, and trading ranges.
Traders using this approach should keep in mind that a security’s pattern can return at any time and should thus use risk management strategies, such as stop-loss orders, to limit potential losses.
To help you understand better, here’s an example from Sep 2020, when Nifty50 witnessed a false breakout, and traders were taking positions against the trend.
As you can see on the chart, Nifty50 saw selling pressure and ended up forming a bearish candle on the daily chart with a long upper wick. This suggests a false breakout. False breakouts often occur in uncertain markets. Even if the overall trend is bullish, there was heavy selling, and traders preferred to trade against the trend.
So, how can you trade countertrend moves?
There are four steps you need to remember:
1. Identify the opposite candle
When an asset starts an impulse move, a trend line should be drawn first. This support or resistance line can help you differentiate between impulses and countertrend moves.
When an asset is trending, you can keep an eye out for opposite candles to determine when an impulse move is likely to stop.
To proceed to Step 2, you must first find a candle that is opposite in nature to the primary pattern.
2. Confirm the opposite candle
There are two ways in which the pattern can be verified. The first step is to add another opposing candle to the chart. According to the second method, the confirmation candle is part of a reversal pattern.
a. Another opposite candle
A keynote to add here is that this rule will sometimes fail since two opposite candles are not a good confirmation signal. Nonetheless, the success rate of this technique would be greater than 50%, which is sufficient to execute a profitable countertrend strategy.
b. Reversal candle
A candle that completes a reversal candle pattern could also serve as confirmation of the countertrend trade. On the chart, this may be a single hanging man or a shooting star candlestick pattern. The candle could be the second candle in a double or triple bottom candle pattern.
3. Trade the opposite trend
You should consider opening a position once you have confirmed an emerging countertrend price change. If the overall trend is bullish, the predicted countertrend change is bearish. You should open a short place in this manner.
If the overall trend is bearish, the predicted countertrend price movement is bullish. This suggests that you open a long position.
4. Set a stop loss
We recommend you always set a stop loss when you trade a countertrend price move.
If the trend is bullish, set a stop loss above the top between the trend impulse and the expected counter trend move. If the trend is bearish, place a stop loss below the bottom between the trend impulse and the expected counter trend move.
Pros of Countertrend trading
So, now that you have learned what countertrend trading is and how it works, here are some of its pros.
a. More trade possibilities
When a security’s price oscillates within a trading range, it provides several opportunities to buy at support and sell short at resistance. If an investor just trades pullbacks in a trending market, he/she can have to sit on his/her hands for an extended period.
b. Smaller losses
Countertrend strategies usually have shallower drawdowns when opposed to trend-following strategies because traders take smaller profits more frequently. While a trend strategy can result in larger overall gains, the trader can be stopped out several times before catching a big move.
Are there any cons of countertrend trading?
Unfortunately, no trading approach is a holy grail. So, when trading against the trend, you need to watch for:
Taking advantage of more trading opportunities necessitates paying more commission fees. Traders who use a countertrend strategy and expect to make a large number of monthly transactions should think about using a per-share commission structure.
This means that the broker charges a flat fee per share rather than a fee per trade. Traders only pay a fee based on the number of shares traded, allowing them to easily scale in and out of positions.
Since countertrend moves do not last as long as trending moves, you must check the markets regularly to find the best entry and exit points for their trades. You can solve this weakness by automating their countertrend strategies.
Although going against the trend can be lucrative, it should be noted that it is a more challenging form of setup for consistently beating the market.
Nonetheless, more experienced traders should spend some time researching different mean-reverting trends in the market and consider incorporating these strategies into their overall trading methodology.
Keep learning Keep growing.