What is a countertrend strategy?
A countertrend strategy attempts to make small profits by trading against the broader current trend. Traders also refer to the practice as counter-trend trading.
It is a form of swing trading that assumes that a prevailing trend will see reversals and will try to profit from them as the trend continues. Counter trend trading is generally a medium-term strategy in which positions are held for several days to several weeks.
- A countertrend strategy targets temporary corrections in the price action of a trending security to make a profit.
- The strategy involves buying / selling a security that has experienced an impulsive bearish / bullish move in the hope that a higher / lower corrective move will allow them to sell / buy it again at that higher / lower price.
- Countertrend strategies use momentum indicators, reversal patterns, and trading ranges to determine the best areas to execute trades.
Understanding the countertrend strategy
A countertrend strategy targets corrections in the price action of a trending security to make money. Opposing traders often implement countertrend business strategies. The strategy involves buying / selling a security that has experienced an impulsive bearish / bullish move in the hope that a higher / lower corrective move will allow them to sell / buy it again at that higher / lower price. The buy-low-sell-high paradigm is satisfied in either case and the merchant’s account is the beneficiary.
Traders using this strategy make smaller profits and are prepared to stop if the expected correction does not manifest. A countertrend strategy ignores the popular investment philosophy that the trend is your friend, at least for the moment.
Countertrend strategies use momentum indicators, reversal patterns, and trading ranges to determine the best areas to execute trades. Traders using this strategy should always keep in mind that a security can resume its trend at any time and therefore should use risk management techniques, such as stop-loss orders, to limit potential losses.
Construction of a countertrend strategy
Traders can use momentum indicators, such as the Relative Strength Index (RSI), along with price support and resistance areas to locate high-probability turning points. For example, a countertrend trader can buy a security if it finds support at a 52-week low and the RSI gives an oversold reading below 30. Conversely, the trader could open a short position if the security’s price reaches a resistance area and the RSI is moving above 70.
To add further confirmation, the trader can wait for a bullish or bearish candlestick pattern before entering the trade. The countertrend range should be wide enough to have a profit target that is at least twice as wide as the stop loss. For example, if a trader is using a stop loss of $ 5, the profit target must be at least $ 10.
Benefits of using a countertrend strategy
More business opportunities
When the price of a security oscillates within a trading range, it presents many opportunities to buy support and sell short resistance. An investor may have to sit on his hands for an extended period if he is only trading pullbacks in a trending market.
Counter-trend strategies generally have smaller drawdowns compared to trend-following strategies, as traders make smaller profits more regularly. Although a trending strategy can produce more substantial gains overall, the trader may be paused multiple times before catching a big move.
Limitations of using a countertrend strategy
Acting on more business opportunities results in paying more commissions. Traders using a countertrend strategy and anticipating a significant number of transactions per month should consider using a per share fee structure. This means that the broker charges a fixed fee per share rather than a fee per trade. Traders then only pay a commission for the number of shares they trade, allowing them to scale in and out of positions more frugally.
Counter-trend moves don’t last as long as trend moves; therefore, traders must frequently monitor the markets to find the best entry and exit points for their trades. Traders can automate their countertrend strategies to overcome this limitation.