One of the oldest adages in all of commerce is that “the trend is your friend.” Since the trend defines the predominant direction of price action for a given security, as long as it persists, more money can be made by following the current trend than fighting it. However, it is instinctive to want to buy at the lowest price and sell at the highest price. The only way to do this in financial markets is to try to “buy the bottom” and “sell the top”, which by definition is a countertrend approach to trading.
Each trading day the fight unfolds between those who are trying to buy or sell in an established trend and those who are trying to buy near a low and sell near a high. Both types of traders have very compelling arguments for why their approach is superior. However, interestingly, in the long term, one of the best approaches might involve merging these two seemingly disparate methods. Often times the simple solution is the best.
A combined approach
Two actions help to successfully combine trend and counter trend tracking techniques:
- Identify a method that does a reasonably good job of identifying the longer-term trend.
- Identify a countertrend method that does a good job of highlighting pullbacks within the longer-term trend.
While finding an optimal approach may take some time and effort, the potential usefulness of this concept can be highlighted using some very simple techniques.
Step 1: identify the long-term trend
In Figure 1, you will see a stock chart showing the 200-day moving average of the closing prices plotted. From a trend-following point of view, we can simply state that if the last close is above the current 200-day moving average, then the trend is “up” and vice versa.
However, for our purposes here, we are not looking for a trend-following method that necessarily triggers actual buy and sell signals. We are simply trying to pin down the prevailing trend. So now we will add a second trend-following filter. In Figure 2, you can see that we have also added the 10 and 30 day moving averages.
So now our rules will be the following:
- If the 10-day moving average is above the 30-day moving average AND the last close is above the 200-day moving average, we will designate the current trend as “rising”.
- If the 10 day moving average is below the 30 day moving average AND the last close is below the 200 day moving average, we will designate the current trend as “bearish”.
Step 2: add a countertrend indicator
There are literally dozens and dozens of possible countertrend indicators that one could choose to use. For our purposes, since we are looking for short-term reversals within a longer-term general trend, we will use something very simple and relatively short-term in nature. This indicator is simply called an oscillator. The calculations are simple:
A = the 3-day moving average of closing prices
class = “rtecenter”>
B = the 10-day moving average of the closing prices
class = “rtecenter”>
The oscillator is simply (A – B)
class = “rtecenter”>
In Figure 3, we see the same price chart as in Figures 1 and 2 with the oscillator plotted below the price action. As the underlying security falls in price, the oscillator falls below zero and vice versa.
So now let’s combine the two methods that we have described so far into one method. In Figure 4, see once again the same bar graph as in the previous three Figures. In this one, we see the 10-day, 30-day, and 200-day moving averages plotted on the price chart with the oscillator shown below.
What an alert trader should look for are cases where:
- The 10-day moving average is above the 30-day moving average.
- The latest close is above the 200-day moving average.
- Today’s oscillator is above yesterday’s oscillator Y
- Yesterday’s oscillator value was both negative and below the oscillator value of two days ago.
Completion of this set of criteria suggests that a pullback within a longer-term uptrend may have completed and prices could be set to move higher. The aforementioned criteria present a scenario in which the trend suggests that the stock should continue its bullish momentum, but the investor will not buy stocks at the peak of the cycle.
There are many potential caveats associated with the method described in this article. First of all, no one should assume that the described method will generate consistent business profits. It is not presented as a trading system, just an example of a possible trading signal generation method. The method itself is simply an example of a single way to combine trend-following and countertrend indicators in one model. And while the concept is completely sound, a responsible trader would need to test any method before using it in the market and risking real money. In addition, there are other extremely important considerations to take into account that go far beyond the mere generation of input signals.
Other relevant questions to ask and answer before employing any business approach include:
- How will the positions be sized?
- What percentage of one’s capital will be risked?
- If and where to place a stop-loss order?
- When should you make a profit?
The bottom line
This is just a sample of the considerations that a trader should take into account before starting to trade any particular method. However, with those caveats firmly in mind, there seems to be some merit in the idea of combining trend-following and countertrend methods in an effort to buy at the most favorable times while still sticking to the main trend at stake.