Does The Trend Really Matter?
We’ve all heard of the saying “the trend is your friend” but the entire saying goes “the trend is your friend, until the end when it bends” and this second part tends to get forgotten. Yes, trading with the current trend or momentum is a very sensible way to trade but can this trading motto prevent us from entering other valid trades? Is it possible to go against the trend sometimes?
This article will try to open your mind to the alternative trades that go against the trend – counter trend trades. It is not designed to try to make you trigger happy and take counter trend trades all over the shop but instead to make you aware of the possibility that counter trend trades can be taken.
How do we determine the trend?
Being able to analyse any chart quickly to find the current trend is something which is very easy to do. By considering both the swing points visible on each chart and where price starts off on the chart and where it moves to, enables us to establish the trend very quickly.
So what does a trend look like, well there are two types of trends to consider:
- A downtrend and
- An uptrend
In a downtrend, we will see price start from the top left of the chart and move downwards towards to lower right hand side of the chart. The classic looking downtrend will look like price is zig zagging or stepping lower towards the right side of the chart, with lower lows and lower highs.
In an uptrend the reverse happens with price starting in the lower left corner and moving higher towards the top right of the chart. Printing higher highs and higher lows.
Once we have identified the trend for a chart, the process of finding trades becomes a lot easier and by knowing the market bias we can differentiate between which are the trend trades going with the current momentum and also which are the counter trend trades going against the current momentum. This information is crucial when deciding how to manage individual trades.
So, why bother with counter trend trades?
If the markets where able to sustain continued trends day in, day out then this article would be redundant but unfortunately the reality of the Forex markets is that Forex pairs do not tend to trend a huge amount of the time in fact they can be seen to go through periods of sideways or consolidation movement on a more regular basis. This then opens the door to the possibility of counter trend trades as being a valid option.
When we take counter trend trades we are not trying to be so bold as to expect the market to roll over and begin a massive reversal – no! We are merely looking to take profit from the pullback of price before the chances of the original trend kicking back in increases. Where we should be looking to get back into trends.
Where can we look for counter trend trades?
Counter trend trading is without doubt going to be more difficult than trend trading because we are looking to profit from price movements against the current market momentum, so yes this will mean that price is more likely to experience more resistance than a trade going with the trend but this shouldn’t scare us off from taking these types of trades. By making adjustments to our trade management and expectations we can manage these risks to allow for these issues.
The location of where we look for counter trend trades is without doubt the most important factor to consider. We do not want to be trading from weak minor levels but from key daily levels that which in the past have shown us to produce strong reversals and the ability to reverse price movements.
Take a look at the Daily chart below, although this pair has been pretty choppy with price moving more sideways than anything, we can use the data printed on the chart to work out where possible reversals could occur. We begin by looking to the left of where price is currently trading and scan backwards to see where price has reacted strongly in the past. The level highlighted in yellow has shown to be an area which has acted as previous resistance and turned price around, so it’s reasonable to consider the same thing could happen in the future.
If we look at what the market is doing currently, we can see it has made a strong continued bullish movement higher and has reached the highlighted level which would be a valid area to look for possible bearish signals. Once we have these areas to watch we need to see some large price action signals to indicate a rejection and to give us an entry point to get into a bearish trade. To date we have only seen price touch the level once and it has shown some rejection indicated by the candle wick but this is in no way a signal to consider taking but we may get another retest and then a valid bearish signal to consider a short trade.
The best time frame to use to find these key levels where counter trend trades could form, is as always the daily time frame and the daily time frame is the best place to seek out counter trend trades. Lower time frames should be used primarily for looking for trend trades going with the current daily momentum.
What should we ask of the price action signals?
By now I hope you should know how the size of the price action signal plays a very important role in determining whether or not it is valid. Looking for signs that price could reverse against its current trend increases the requirement of the price action signal to be a dominant signal and this is relayed back to us in the form of the size of the price action signal, the larger the signal indicates a more powerful signal. If the price action signal really stands out from the rest of the price action around it and is larger in size than the candles in the recent swing then the price action is valid.
The chart below, shows how price broke through a key level (red line) and yes the safe bet to getting into a trade would be to wait for price to pullback lower and look for a bullish price action signal to from rejecting the broken key level. However, when a large reversal candle forms like this large pin bar I think it is possible to enter a short trade and ride the pullback lower. The size of the pin bar is great because if you compare the size of the candles contained in the upward swing, the pin bar is the largest candle and so indicates to me that it has a lot of power or momentum behind it.
Do we need to alter our trade management and expectations?
When we enter a trend trade we expect the ride to be a little easier as we are in essence going with the flow, however taking counter trend trades against the current trend is more like trying to walk through a crowd of people coming towards you, the flow is against you. So naturally there will be more resistance and this may cause the movement of price to be a lot more choppy and sideways but this is to be expected and is simply a part of counter trend trading.
Before, we enter any trade we need to work out our entry point, stop loss and take profits. The entry points stay the same regardless of what type of trend the trade is trading with. The stop loss and take profits are a different matter though, let’s consider the stop loss first.
Stop loss management
Whenever we decide to take a counter trend trade we need to be aware of the increased possibility of trades finding more resistance and preventing price from moving freely to our targets. As always we need to try to get the balance correct between covering our positions but allowing trades the space to breathe. If we accept the fact that the chances of price retesting our entry point are much higher compared with a trend trade we must try to factor this into our stop loss management.
This issue of price retesting entry points is the reason I came up with the “stop loss buffer”, unfortunately this is part of the advanced course and so not something I can explain any further in this article but it is something to consider when taking counter trend trades.
When setting take profits targets we again need to recognise the chances that price will make a massive move in our favour is much less likely. We need to instead be more conservative with our profit targets and and try to profit from the pullback before the dominant trend kicks back in. Granted by setting more conservative profit targets reduces the risk reward compared to a trend trade but being realistic and appreciating the market conditions will produce far more consistent results.
Its paramount that we have different trade management techniques for both trend and counter trend trades because they both possess slightly different market conditions and to get consistent results from both types of trades requires different approaches.
An example of a counter trend trade I took recently
At the time of putting this article together I had recently entered a counter trend trade and I thought it would be helpful to really show you how and why I considered the trade to be valid and worth taking.
The pair this counter trend trade formed on was the CAD/JPY and I will now go through the process of how I found the trade trade and how I looked to manage it.
The first step is as always to find the key levels at which we want to look for potential trades. The CAD/JPY had been on a very bullish move and momentum was upwards but as I have mentioned already there is always going to be a point when the chances that price could reverse becomes higher.
If we look at the daily time frame and scan the chart we can see that the pair was trading in an area which it hadn’t been active in for a long time. This meant for me to find a key level which could potentially turn price around, I had to turn to the weekly chart to get a more zoomed out image of what price has done in the past.
By checking out the weekly chart I was able to spot an area where price had been rejected from in the past. I marked this level and then proceeded to drop back down to the daily time frame and wait to see if any large bearish price action signals formed.
When price reached this key level on the daily chart, we actually had a lovely large bearish engulfing bar (BEEB) form and what I liked was the fact that in the recent swing higher which contained 6 other daily candles the BEEB was the largest of the lot. So I felt like I had found a solid price action signal at a key level but the next step was to consider whether or not the trade had space to move back into.
I felt the chances that price would retest the most recent swing low was very high and so this acted as my first trouble area (FTA). At this when price reaches an FTA the idea is to protect ourselves from price retesting our entry point and we do this by moving to breakeven. I did do this but instead I used a slightly different method called the stop loss buffer. This is something I teach to the advanced members.
Price has continued to fall lower and although it still has a way to go, I am looking to close the trade out at the next important key level where the original trend has a higher chance of kicking back in and causing price to move back higher.
This trade no matter what it does from the time of me writing this article will be at worst a break even trade and I feel I have chosen conservative yet realistic targets to get the most out of this trade opportunity and if price does fall lower to this point I will be very happy with the outcome.
I will not follow this trade too closely, probably just checking on it at the end of each daily close but letting my original trade plan set out before entering the trade to manage it.
Are counter trend trades worth the risk?
Counter trend trading for me is definitely not about trying to pick tops and bottoms of trends but if we understand the principle that as price increases to over extend the chances that it needs to find value, increases to and this is why pullbacks exist. So, we take counter trend trades on the premise of trying to profit from price pulling back to find a value area.
Taking counter trend trades on lower time frames is not recommended, instead I advise you to stick with the daily time frame and only look to trade against the trend with daily price action signals. Daily signals are more powerful and consistent and so increase the chances of the signal working.
To summarise, just like most price action signals they need to:
- Form and reject key daily levels
- Be large in size and dominant and
- Have space to move into
Being especially picky with which trades to take counter trend is something we need to focus our attentions on, if a signal forms and it doesn’t quite scream out “trade me!” it’s best to stay away.
But they also require further trade management tweaks to the stop loss and take profit targets, to compensate for the market conditions present when taking trades against the current trend.
Therefore, my expectations of a trend trade compared to a counter trend trade are completely different. I try to be as realistic as possible and understand that counter trend trades are going to need more conservative take profit targets than a trend trade and the overall risk reward will never be as high as a trend trade would be. Nevertheless, if a counter trend trade presents itself at the right location with space to fall into then the trade will be taken.
I want to make it clear, trend trading should form the core focus of our trading but with the addition of counter trend trades to our repertoire we can increase the opportunities available to us to enter trades.
This article is not intended to turn you into a counter trade trader over night but instead to explain and show you how counter trend trades can be found and managed in a proper manner.
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Regards and happy hunting