Is Counter Trend Trading the road to ruin? One of the reasons many new traders lose money day trading is because they cannot break the desire to counter trend trade, or to try and pick tops and bottoms. Unless prices are in what I would describe as a “trading range” type day, it is very unwise to try and pick tops and bottoms. Generally, when a market looks poised to change direction, that is often times the best point to get back on board with the longer-term trend.
The best entries come just as the market trend seems to be failing and finally ending. The with trend entry looks like the last thing you would want to do, and this is when most of your weak hands are sucked into the wrong side of the market, just as it is making a low in a bull trend pull back, or making a high in a bear trend pull back. It is uncanny as to how often this will happen to even experienced traders that should know better.
Thinking back on your own trading, how many times have you watched a strong market making new highs, and then suddenly it starts to struggle to move higher? It then makes a nice leg down, before turning up again, only to stall with a lower high. It looks like the trend is changing, and the market is now looking very bearish. You tell yourself that now is the time to enter count trend, so you set your orders and enter the market short, feeling certain that you have outsmarted everyone else and are getting in on a trend reversal with perfect timing.
Some times you may get a few ticks of movement in the right direction after entering, but if not almost immediately, then soon thereafter, the market suddenly hits a brick wall and starts rising again. What just looked so bearish is now looking very strong again and within a few bars, the market is racing to another new high and you are stopped out with a loss. If this sounds familiar, then know and understand that it happens to many traders, including experienced traders that really should know better.
I am going to share with you what I believe is the proper way to try and determine when a market really is rolling over and when and why you should stay with the trend in most cases. The first thing you absolutely must see happen before ever considering a counter trend trade is the break of an important trend line. It should also be a convincing break of the trend line and not just a few ticks through it. Until you see that convincing break of a trend line, you should always be looking to take with trend entries on pullbacks.
Even when you see a convincing break of a trend line, you will most always see prices attempt to test the previous high or low, so even a convincing break of a trend line should first have you looking for another with trend entry. Prices like to re-test important highs and lows, so remind yourself of that every time you are considering a counter trend trade. The hardest part of this piece of the puzzle is trying to determine when the pull back is done and when the move to re-test will begin. While there is no right or wrong answer, as every move is different, just know and understand that a re-test is very likely before you will get any new trend in the opposite direction.
Once you get a convincing break of that all important trend line, the general rule of thumb is that prices will try and do one of two things. We already know from our previous discussion that prices will almost always try and re-test the previous market high or low, but there are usually two different scenarios that you must watch for to occur. One, Prices will either go on to make yet another new high before turning over, or two, they could make a lower high in a failed re-test. If prices go on to make a new high, you should see at least a two legged correction after doing so unless the trend is simply too strong and prices resume the original trend. On the other hand, if prices make a lower high, then you should see at a minimum, at least one more leg down. This will actually be a two-legged correction, but the pull back off the high actually creates leg one.
In addition to the trend line tool, there is one other rule I use to help keep myself on the right side of the market. That rule is based on where prices are in relation to a 21 bar EMA. If most of your price bars are above the EMA, then that is generally a clue that you should be looking for longs. If prices are mostly below the EMA, then that is a clue that you should mostly be looking for shorts.
Following this one simple rule, you can usually keep yourself on the right side of a trade. The one time this rule fails most often is when prices are in a trading range. Trading range days will see prices moving from one side of the EMA to the other more often. Look at a few charts and see what happens with the EMA in most strong trends. Prices will stay on the side of the EMA with the trend, and the EMA will serve as a good indicator as to when to actually enter the trade as well, since most pull-back’s will stall at or near the 21 bar EMA.
What you should now understand from our discussion is that you should only be looking for with-trend entries until there has been a convincing break of an important trend line. Even after that convincing trend line break, you should still be expecting a re-test of the prior high or low, so still no counter trend trades until after that happens. Unless you are experiencing a choppy and non-trending day, you can improve your trading considerably by simply NEVER counter trend trading. By taking only with trend entries on strong trending days, you can improve your bottom line and reduce your losing trades considerably.
Take the time to study some charts and see what happens at these major lows and highs. See if this theory of counter trend trading, the road to ruin does not hold up in most cases. Staying with the trend, and following these simple rules will usually keep you on the right side of the market, and most importantly, you will be a happier and wealthier trader.