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Trading Counter Trend: Trading Tactics and Risk Management
BY Janne Muta
|July 25, 2024Trading counter trends involves making trades that go against the prevailing market trend, contrasting with trend-following strategies. This approach capitalises on market corrections and the potential for reversals, making it a preferred option for some traders.
Please note that any mention of profit in this article is intended to state that traders generally seek to profit from trading, but this inherently involves accepting substantial risks. This article does not attempt to create an impression that profits can be generated easily and without the risk of significant loss. Readers should be aware that trading carries a high level of risk to your capital. It is important to fully understand the risks and seek independent advice if necessary.
Mean Reversion & Divergence
Common counter-trend strategies include mean reversion, where prices return to an average level, reversal patterns that signal trend changes, and divergence trading, which identifies discrepancies between momentum and oscillators such as RSI. However, these strategies carry inherent risks as trending markets are likely to keep on trending. If the trend continues those trading counter trends will suffer losses. Therefore, highly disciplined risk management and the use of stop-loss orders are crucial.
Despite the risks, counter-trend trading offers diversification potential and more optimal risk-adjusted returns if used correctly. Highly experienced traders use counter trend trading to complement other trading strategies in order to smooth out the equity curves of their strategies. For instance, by trading counter-trend so-called trend followers might aim to lock in gains during corrective phases where the market retraces back towards the trade entry.
This article discusses various aspects of counter-trend trading, offering insights into strategies, risk management, and tools to help traders effectively navigate this challenging yet rewarding approach.
Understanding Market Trends
An uptrend features higher lows and higher highs, indicating that the market is more likely to break resistance levels as demand is greater than supply. An uptrend is typically identified by upward-pointing moving averages and prices trading above these averages. While trend followers look for these signals to confirm that the market is worth buying , those trading counter trends look for opportunities to short the market when they rally into new highs and start to lose momentum, betting on mean reversion.
In contrast, a downtrend is characterised by lower highs and lower lows, suggesting that the market is more likely to break support levels as supply exceeds demand. Indicators of a downtrend include downward-pointing moving averages and prices trading below these averages. Recognising these patterns is crucial for trend-following traders as they anticipate market declines and look for trades on the short side. Counter trend traders however seek to gain from occasional retracements in the trend after the market has moved “too far” in their opinion and might show signs of strength.
Popular Strategies for Trading Counter Trends
Counter-trend trading involves capitalising on short-term corrections within an established trend. Here, we explore two popular strategies: Mean Reversion and Reversal Patterns. Each strategy has unique principles and applications, making them valuable tools for traders seeking to benefit from market fluctuations.
Mean Reversion
Mean reversion is based on the idea that prices, after moving significantly away from their average value, will eventually revert to that average. This concept relies on the statistical principle that extreme price movements are temporary and will return to their mean over time. The strategy assumes that markets are inefficient and that prices can deviate from their intrinsic value due to investor behaviour, such as overreaction to news or earnings reports.
Traders using mean reversion typically look for securities that have deviated significantly from their historical average prices. They then enter trades with the expectation that prices will revert to the mean. This approach often involves identifying overbought or oversold conditions using indicators like the Relative Strength Index (RSI), Bollinger Bands, or Moving Averages.
Scaling Into Positions
In markets that trend higher, the consistent uptrend is driven by a greater institutional demand than supply. This dynamic remains as long as the uptrend continues. Viable strategies for trading counter trends therefore necessitate identifying those moments when institutional traders are not actively bidding for the market and might be selling contracts they bought earlier. Identifying these pivotal moments requires expertise and can pose considerable challenges, even for highly experienced traders.
To mitigate risks and enhance potential returns, some traders adopt a strategy of scaling into positions near or above recent reactionary highs. This approach allows them to gradually build their positions as the market moves into new highs, potentially benefiting from the anticipated reversal. By scaling in, they can manage their exposure and better manage the risk associated with counter-trend trading.
During uptrends markets can move beyond recent reactionary highs significantly before a counter-trend move occurs. Consequently, some traders trading counter trend initiate a small short position when the market surpasses the most recent prominent reactionary high, adding to this position as the market continues to reach new highs.
In an imaginary Forex trade, (see the EURUSD chart above) the first short position is opened at 1.0820 as the market rallies past the 1.0817 high. The strategy involves building the full position in stages. A trader might allocate 20% of the intended full short position to this initial entry, adding more as the market climbs higher.
The next portion is added at 1.0830, representing 40% of the total intended short exposure. Finally, the trader completes the position by adding the remaining 40% at 1.0840. This staged approach results in the trader having a volume-weighted average price (VWAP) of 1.0832 for the short position. If our imaginary trade was closed e.g. at 1.0815 the trade resulted in a gain of 17 pips.
The market can keep on moving higher, and often does, so it is imperative to use a stop loss order to limit the maximum loss to a level that doesn’t create too big of a risk to the trader. Another way of limiting the risk associated with counter trend trading is conservative position sizing. Often traders risk only a small portion of their funds in any given trade. The amount some traders use could be 0.5% or 1% of the trading account.
Using the RSI Indicator When Trading Counter Trend Strategies
The above AUDUSD chart shows the market trending higher but pausing or retracing every now and then. These retracements show up in the RSI seven period indicator as consecutive lower peaks. RSI is a momentum indicator and as such reacts to the market losing to upside momentum by diverging from the price.
When the divergence appears, traders might consider entering short trades near a recent high. The divergence between price and RSI signals a potential short-term reversal during the uptrend, offering an opportunity for counter-trend trading.
However, it is important to note that targets should be placed relatively close since counter-trend moves might be shallow. This can help traders to exit the short trades at favourable levels before the market resumes its upward trajectory.
Stops could be placed above the latest highs to a safe distance away from the price fluctuation to avoid the market triggering the stop unnecessarily while limiting the potential loss.
Reversal Patterns
In technical analysis, observing higher reactionary lows following a downtrend is a crucial signal, often indicating a potential reversal in the market. These higher lows form when the price dips but not as far as the previous low, suggesting a diminishing bearish sentiment and a growing bullish outlook among key market players.
This pattern primarily results from institutional buying. When major financial entities like hedge funds, pension funds, and other large-scale operators begin purchasing at levels above the previous low, it demonstrates a shift in their market sentiment from bearish to bullish. This is when those trading counter trends can see the expected value of their trade setups increase.
Institutional support is essential because these entities have significant financial leverage and the capability to influence market trends. Their buying decisions are often based on thorough research and analysis, making their actions particularly noteworthy for individual investors.
For retail traders, the power to reverse a downtrend or forge significant bullish patterns is limited due to their relatively smaller capital. They typically lack the market influence required to shift price trajectories on a large scale. Therefore, their strategies often include watching for signals initiated by institutional traders to make informed decisions.
If the market remains bullish after forming a higher low, the likelihood of a sustained upward trend increases. This scenario provides a more favourable environment for both institutional and retail investors to capitalise on potential gains. Identifying these patterns early can be a valuable tool in traders’ toolkits, helping them to align their positions with institutional fund flows.
Risk Management in Counter Trend Trading
Risk management is crucial when trading counter-trend, as traders aim to profit by making trades against the prevailing market direction. While this approach can offer opportunities to profit from the counter trend moves, it involves significant risk. Therefore, managing potential losses is essential. Effective risk management techniques can help traders minimise losses and improve their chances of achieving consistent returns, but they do not eliminate the inherent risks of counter-trend trading.
Risk Allocation and Position Sizing
One fundamental principle in counter-trend trading is to limit risk. Some traders opt to risk 0.5% to 2% of their trading capital on any single trade. This rule helps to protect your trading accounts from significant losses. Beginners should err on the side of caution, risking less capital per trade, while more experienced traders with proven strategies might consider slightly higher risk per trade.
For example, if a trader has a £10,000 account, risking 1% per trade would mean risking £100. This fixed risk per trade helps maintain consistency and prevents overexposure to any single position.
Stop-Loss Orders and Their Placement
Stop-loss orders are essential in trading in general but even more so when trading counter trend. These orders automatically close a trade at a predetermined level of loss, protecting the trader from further downside. However, placing stops too close to the entry point can result in frequent stop-outs, especially in volatile markets. This could have a negative impact on the overall profitability of the strategy as the probability of the market stopping trades out would increase, possibly preventing the strategy from achieving the intended profitability goals.
To avoid this, traders should place stops far enough from the entry price to account for normal market fluctuations, increasing the probability that their strategy has a statistical edge. Note that the bigger stop size should also mean the position size is smaller so that the risk doesn’t grow beyond what’s defined in the trading plan.
Stop placement requires a thorough understanding of market behaviour and volatility. For instance, using technical indicators like the Average True Range (ATR) can help determine a reasonable stop distance.
Keeping Risk Constant While Varying Position Size
Maintaining a constant risk level while varying the position size helps traders maintain a disciplined and systematic approach to trading. As the distance between the entry and stop-loss prices changes, traders should adjust their position sizes accordingly to keep the risk percentage consistent.
For example, if the entry price and stop-loss are close, a trader might take a larger position size to maintain the same level of risk. Conversely, if the stop-loss is far from the entry point, the position size should be smaller to keep the risk constant. This approach ensures that the trader's market exposure varies with the volatility and risk of the trade, but the overall risk to the trading capital remains stable. This supports healthy trading psychology as risk remains under control and within the trading plan.
Adjusting Trade Size Based on Confidence Levels
More experienced traders trading counter trend strategies use variation in their bet size. The market exposure they take is based on their confidence in the trade setup or the reliability of the trading pattern. If a trader is highly confident in a trade setup or has a pattern that has shown strong historical reliability, they might choose to risk more. Conversely, if there are uncertainties or the pattern is less reliable, the trader should reduce the trade size.
For instance, a trader might decide to risk 2.5% of their capital on a highly confident trade, but only 1% on a less certain setup. This variation allows traders to leverage their experience and statistical knowledge about their favourite trading setups while still maintaining a structured risk management framework.
Conclusion
In conclusion, trading counter trends involves capitalising on market corrections and potential reversals, offering a strategic alternative to trend-following methods. This approach requires disciplined risk management, including the use of stop-loss orders and conservative position sizing, to mitigate the inherent risks. When executed effectively, counter-trend trading can enhance diversification and improve risk-adjusted returns. As traders integrate these strategies, they can better navigate market fluctuations and optimise their trading performance. To take advantage of these strategies and more, consider opening a trading account with TIOmarkets.uk, an FCA-regulated broker.
While research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.
TIO Markets UK Limited is a company registered in England and Wales under company number 06592025 and is authorised and regulated by the Financial Conduct Authority FRN: 488900
Risk warning: CFDs and Spreadbets are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when trading CFDs and Spreadbets with this provider. You should consider whether you understand how CFDs and Spreadbets work and whether you can afford to take the high risk of losing your money
DISCLAIMER: TIO Markets offers an exclusively execution-only service. The views expressed are for information purposes only. None of the content provided constitutes any form of investment advice. The comments are made available purely for educational and marketing purposes and do NOT constitute advice or investment recommendation (and should not be considered as such) and do not in any way constitute an invitation to acquire any financial instrument or product. TIOmarkets and its affiliates and consultants are not liable for any damages that may be caused by individual comments or statements by TIOmarkets analysis and assumes no liability with respect to the completeness and correctness of the content presented. The investor is solely responsible for the risk of his/her investment decisions. The analyses and comments presented do not include any consideration of your personal investment objectives, financial circumstances, or needs. The content has not been prepared in accordance with any legal requirements for financial analysis and must, therefore, be viewed by the reader as marketing information. TIOmarkets prohibits duplication or publication without explicit approval.
Janne Muta holds an M.Sc in finance and has over 20 years experience in analysing and trading the financial markets.
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