Last Updated on 10 February, 2024 by Trading System

The majority of trading systems out there are trend-following systems. However, swing traders and day traders sometimes trade the counter-trend swings. But what does counter-trend trading really mean?

Countertrend is the direction of price opposite the primary trend of the market. This move is usually a correction in the existing market trend and usually lasts for a short duration. While following the trend seems to offer a higher probability profit potential, a counter-trend trading strategy will work out as well.

In this article, you’ll learn what a counter-trend is and how to use it. To help you understand this topic, we will discuss it under the following headings.

• What is a counter-trend?
• Understanding counter-trend trading strategy
• How to develop and trade the counter-trend strategy
• When to use a counter-trend strategy
• Benefits of using the counter-trend strategy
• Limitations of using the counter-trend trading strategy

What is a counter-trend move?

A counter-trend swing is a correction in the price of an asset against the main trend. Simply put when a market is in an uptrend and it makes a pullback, we can say that the pullback is a counter-trend because it goes against the initial trend (uptrend) of the market.

Fig 1.0. Cocoa Futures Daily Chart

Source: MetaTrader 5

From the above chart, you can see that the major trend is to the upside, but there were some pullbacks (orange line) in price. These two were highlighted to keep the charts clean. Even within small rallies, we can also see a small pullback. This is a condition the market will present to you every time.

Traders who trade using this approach look at indicators like the RSI and MACD for their buy and sell signals.

Understanding counter-trend trading strategy

A counter-trend trading strategy is an attempt to make smalls profits by taking a trade against the primary trend. Countertrend trading is a form of swing trading that assumes that the current market trend will experience reversals or pullback and then attempts to gain from the pullback as the primary trend continues. This strategy is a short-term strategy whereby positions are held for days or several weeks.

Some traders that employ this strategy to make some profits from pullbacks while maintaining their main positions in the trend direction. Countertrend strategies use momentum indicators, trading ranges, and candlestick patterns to spot possible points to enter the market. It is, however, necessary that traders who use this method should be cautious that the can resume its current trend at any moment without a warning. Thus, proper risk management techniques such as stop-loss orders and minimal position sizes should be employed when trading using this strategy to limit losses.

How to develop and trade the counter trend strategy

Before you think of trading using this strategy, you must first know the market you’re going to trade. Second, you should have a trading plan and also determine what indicators you are going to use and your rules for entry and exit.

You can use momentum indicators such as the Relative Strength Index (RSI), Stochastic, Moving Averages, CCI, or the Williams % R, with price support and resistance areas to spot high probability reversal points.

For instance, you may sell a security if it hits resistance at a 52-week high and the Stochastic is at the overbought region above 80. Also, you can open a position to buy when stochastic is below 20.

Below are some steps to take when using the counter-trend strategy:

• Define your reference point: You should know what you’re looking at on the chart as a point of reference. For example, it could be an all-time high or low, a 52-week high or low, or a multi-year high or low, key support and resistance levels. You must have a point of reference that you can look to.
• A strong move towards your point of reference: Let say you trade commodities, for instance, Gold, and maybe price had declined to an all-time low to $1400, and then it had an 800 pips rally and then pull back again towards the $1400 price level. You want the price move towards that level to be as aggressive as possible with long bearish candles. The more bearish the market is, the more significant the momentum is, and the better because this move usually goads short traders to sell the pullback. When the price breaks below the $1400 level which is an all-time low, this will be a point of interest to many traders. Most of the traders at this point will short the market below this point. This is the mentality of most traders around the world as they keep an eye on this bearish price action on the charts. But here’s where this gets interesting, in most cases, this is a trap most traders fall into. As soon as price breaks a major support line, they go head-on and short it and this happens next… A fake breakout!
• Watch for price to do a false breakout: What a false breakout means here is that price breaks below the all-time low on the Gold and then reverses back to the opposite direction and closes higher than the previous day. Traders who sold at that level are pretty caught up in the reds. A counter-trend trader can take advantage of this bounce back and go long because the price tried to break the support but reversed and instead rallied higher. At this point, this is not reckless trading because now you have your reference point to enter and exit the market, and can set your stop-loss below the swing low. But if the market continues its downward move, you’ll be out of the trade quicker.
• Set a reasonable stop loss: Stop-loss is not just some random numbers you throw in because if you were to do that, you’d be stopped out real quick. You should set your stop-loss below the swing low. A reasonable trader knows there won’t be any reason to stay in a trade that has broken below that point (swing low). Before setting your stop-loss, make sure you’ve attended to your risk management and the amount of capital you’ll expose to the trade.
• Have a realistic profit target: Because you’re a counter-trend trader, your profit target should be conservative — you want to make small gains from the corrections as quickly and possible. You don’t want to aim for the moon or the next 1000 or 2000 pips. Most times what the market does is a brief rally of about 200-300 pips before the move ends and then the price dips lower, resuming the downtrend. You will see this scenario play out often.
• Mind your position sizing: You shouldn’t play around with your position size when counter trading because your risk getting yourself into an uncomfortable situation if you try to scale in. And never add to a losing trade, cut your losses early as well as you take profit.

You should therefore take your bite of the market as quickly as possible instead of waiting for a big retracement which in most cases won’t happen. This is how a counter-trend trader trades the market. And this strategy is suitable for any market.

When to use a counter-trend strategy

By now you know what counter-trend is and how to develop your strategy. So let’s look at the type of market condition you can apply this.

·        Trending market

When the market is in an uptrend, what you should be looking for are minor pullbacks in the market. Since this pullback doesn’t last for long, you want to be able to spot it on time. One way you can do this is by using a momentum indicator like the RSI.

Look for sell opportunity when the indicator reading is above the overbought levels in an uptrend and buy when below the oversold level in a downtrend.

The above chart clearly showed that the market was in an uptrend. With our indicator (RSI) below the chart, we wait till it crosses above 70 and then looks for some patterns like a bearish engulfing as a confirmation or a break of market structure to the downside to confirm a retracement. Stop-loss would be set above the swing high and then profit target would be realistic, a 1:1 and 1:2 would be ideal since the market might not give enough room for a decline before resuming its move to the upside.

• Sideways market

A ranging market is a market without a trend. Prices are moving back and forth within a channel. This presents one of the best trading opportunities for the counter-trend trader. Before going about spotting potential market entry and exit points, you should draw support and resistance lines in conjunction with any momentum indicator that suits you as shown in the above chart.

A counter-trend strategy within a range is more effective than in a channel. You go long when your indicator is at the oversold level and go short when the indicator reading is above overbought. It applies to any timeframe on the chart.

• Volatile market

A volatile market is one with large price moves within specific periods. It is usually characterized by a long body of candles and wicks. While this is a very risky environment to trade, it poses more trading opportunities to a risk-taker. The only drawback in trading in this market is you might get stopped out frequently because of the large swings in price.

One such market is the Cryptocurrency market which is known to experience wide swings within a short timeframe.

Example of a Countertrend trade

Let’s a look at the EUR/USD hourly chart below.

Our trade rules for this particular pair are as follow:

• Determine a major trend (in this case an uptrend)
• Insert indicator (RSI)
• Sell only when RSI is above 70
• Wait for a bearish candle as further confirmation
• Sell when candle break short term market structure
• Set stop loss above the short-term high (swing)
• Take profit target is 1.5x the stop loss
• Exit position if the price goes against entry

Benefits of Using the Countertrend Strategy

These are some of the benefits:

• Lots of trading opportunities: When the price of a security move within a range, it presents many buy-sell opportunities at support and resistance levels. This is not true for a trend follower who has to wait for the market to be in either an uptrend or downtrend to enter the market. Some ranges may take weeks or months before finding direction.
• Minimum drawdowns: Countertrend strategies usually have minimum drawdown compared to trend-following strategies. Countertrend traders take smaller gains more regularly. However, a trend follower may realize more significant gains overall, such trader may get stopped out many times before making a big hit.

Limitations of using the counter-trend trading strategy

Now that you’ve known some of the benefits a counter-trend strategy can bring, let’s now take a look at some of the limitations you’re likely to face when using this strategy in your trades.

• Accumulates trading commissions: Because you’re presented with more trading opportunities, you’re faced with more commission charges. When you trade with a counter-trend strategy, you make a significant number of trades in a month. Therefore you should consider per-share commission charges. Your broker will charge you a flat fee per share compared to a per-trade fee. It allows you to scale in and out of positions more sparingly.
• Requires lots of screen time: As market corrections don’t last as much as a trending move, you need to constantly watch the market to spot potential entry and exit points for their trades. This is however a time-consuming process but you can automate your counter-trend trading strategy to overcome this problem.

Final words

A counter-trend strategy can be profitable when applied in a trading range or channel, but it is not without risk and is even riskier for new traders. Before using this strategy, ensure you are confident and have back-tested it in a demo account to be sure you’re doing the right thing. Never trade on impulse or because you feel good because a single mistake can result in the loss of some or all of your trading capital.

Due consideration should be taken into the type of market conditions you’ll be applying the strategy because different market conditions will require different risk management approaches.

FAQ

How does a counter-trend trading strategy work, and what is its goal?

A counter-trend trading strategy aims to make small profits by taking trades against the primary trend. Traders using this strategy expect reversals or pullbacks in the current trend and attempt to capitalize on them while maintaining their main positions.

How to identify a counter-trend opportunity and set up a trade?

To identify a counter-trend opportunity, define a reference point (e.g., all-time high/low), observe a strong move toward the reference point, watch for a false breakout, set a reasonable stop loss below the swing low, and have a realistic profit target. Position sizing is crucial for risk management.

How can counter-trend traders manage risk effectively?

Effective risk management for counter-trend traders involves setting reasonable stop-loss levels below swing lows, having realistic profit targets, and minding position sizing. Traders should avoid adding to losing trades and cut losses early.