When Is It Okay to Trade Against the Trend?

Happy Friday!

This week’s question comes from Karol, who asks:

I have a question about playing countertrend moves. Do you have rules for trading these? What criteria do you use to decide whether to play or not?

There is a fine line between being a successful contrarian and betting against an established trend. It’s perfectly okay to challenge the market’s opinion of whether an asset is over or undervalued, but you must have evidence to back up that opinion.

Otherwise, you end up being “that trader” who is always betting against the crowd hoping for a reversal only to get wiped out in the process.

Ask me how I know.

On top of evidence, you also need a favorable risk to reward ratio. Without this one thing, no trade is worth taking, particularly one that’s against the trend.

Let’s begin.

First and foremost, we need to define what a trend is, so we’re all on the same page.

The simple definition is that a trend is the general direction of a market. It can vary in length from short to long-term.

Where a lot of traders seem to get tripped up is when it comes to pullbacks or retracements within a broader trend. These moves are called corrections.

I’ve written about impulsive and corrective moves before, so I won’t go into too much detail here.

The easiest way to determine the trend of any market is to pull up a daily chart, zoom out a little and see which way the market is moving. If it’s trending from the lower left of the screen to the upper right, you know the market is in an uptrend. The opposite goes for a downtrend.

Here’s an example of a trending AUDUSD on the weekly time frame.

The most important thing to keep in mind is that both bullish and bearish trends can be short-term, intermediate or long-term.

The time frames you use will also affect whether you’re looking at an uptrend or a downtrend. For instance, a currency pair can be trending lower on the daily chart and still maintain a broader uptrend on something like the weekly or monthly time frame.

There are times when trading against the trend can be extremely lucrative. In fact, some of my most profitable trades have come from betting against the trend.

I wrote about one such trade here.

But there is one thing all of these countertrend trades had in common – justification, and lots of it.

It’s never enough to buy or sell a market because an indicator says it’s oversold or overbought respectively. Those terms are rather meaningless in my opinion and can get you in trouble in a hurry.

A famous quote comes to mind when I think of the terms oversold and overbought.

The market can stay irrational longer than you can stay solvent.

John Maynard Keynes

So what kind of justification do you need?

That depends on your style of trading and personality. It’s a very subjective thing that only you can determine.

However, I can share with you a couple of methods I use to determine when a countertrend bet may be appropriate.

The first is the head and shoulders pattern and its inverse. This price structure has become my go-to formation when searching for countertrend opportunities.

I wrote a detailed lesson on how to trade the head and shoulders, so I won’t elaborate too much, but I will share a few reasons why I favor this pattern.

1. Relatively easy to identify when you stick to the daily and weekly time frames
2. Precise entries due to a well-defined neckline
3. Extremely lucrative as most head and shoulders form after extended moves (market has more room to run)
4. Targets are easy to identify using a measured objective

The second method I like to use is a little more advanced as it requires a firm understanding of support and resistance. But it’s an excellent way to determine if a market is tiring.

I’ll use the current price action on the NZDUSD daily chart to illustrate this method.

Notice how the NZDUSD has been in an uptrend for the past few weeks. The pair has also taken out a recent swing high. At a minimum, we can call this a short-term uptrend.

Now, the pair recently came into a confluence of resistance as indicated in the chart above. However, instead is simply selling in this area and hoping for a reversal, we wait for a close below key support. That becomes our justification for trading against the trend.

The idea is that if this support area fails, chances are other longs will begin to unwind their positions, which would likely push the pair lower.

Think of it as two forces pushing against each other. If one side starts to retreat and forfeits a key threshold, chances are the other side will begin to assume that lost ground.

In the case of the NZDUSD, if buyers lose the support area shown above on a daily closing basis, chances are sellers will start to advance and thus push the pair lower.

Sure, you miss out on a few pips by not selling higher, but you gain an extra layer of conviction. The outcome is a higher probability trade, which should be at the top of every trader’s priority list.

If you’re going to trade against the trend always be sure you have multiple reasons to do so. These reasons can come in the form of reversal patterns like the head and shoulders or breaks of key support or resistance levels.

The terms overbought and oversold are meaningless as a market can stay irrational longer than you can stay solvent.

Don’t try to guess when a market will turn. Instead, use the key levels and technical patterns at your disposal. Let the market show its hand before you decide to commit to a countertrend position.

It’s always better to gain an extra layer of conviction before pulling the trigger than to try to buy or sell at the absolute bottom or top of a move.

I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.

To do that, I need your help.

Here’s what you can do to get involved and have your question answered in next week’s post:

1. Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
2. Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.