Counter-Trend Trading, Targets and Defining Risk

Blast From The Past

Last week saw me doing something that I don’t usually do much of these days, which was trading counter-trend. When I first started trading I never really paid much attention to the concept of “trend” or “counter-trend”, I tended to trade quite sporadically, in whichever direction I felt there was a “set-up”, and in the early days my idea of what constituted a setup was constantly shifting.

Once I dug deeper into Forex trading and became more familiar with the basic technical and fundamental concepts, I started to achieve more consistency in my trading, both in terms of the type of setups I was taking and the sort of results I was achieving. One of the most important  parts of my learning process was coming to understand the value of trading with the trend, which extends not only to the financial aspect of trading but also the psychological aspect of trading.

Respect The Flow

Trading with the trend is a far more forgiving strategy and will generally lead to more successful, more consistent trading. When you trading in the direction of the major money-flow in the market you are far more likely to catch a move then if you are looking to trade against it. This is not to say that you cannot trade against, just that doing so is a game that requires a lot more experience and skill and is much higher risk.

Rookie Mistakes

One of the mistakes that many new trades make is how they define risk. Traders will look at a counter-trend setup and identify an area where they believe they can enter, using a “tight stop” with the potential for catching a huge reversal. This “tight stop”, is defined as a low risk trade with big upside, however, what many new trades fail to understand is that risk is also a function of how likely it is that your stop will be hit and as such a tight, counter-trend stop is far more likely to get hit than a with-trend trade that has a stop sitting above/below recent support/resistance with plenty of room to allow for momentum to kick in.

Another issue that stems from these “tight stops” and their apparent low risk is that trades tend to attach themselves to visions of catching a huge reversal and become entrenched in their view which generally leads to two or three types of behaviour. The first is that either the trader will take multiple stop outs as they keep trying to fade the trend and catch the reversal, or they will, even more fatally, keep moving their stop further out as they wait for the reversal to happen. Typically the trader who keeps moving his stop out will also commit another foul by adding to their losing positions with the hopes of getting a better “average” price.

In the words of Paul Tudor Jones – “Losers average losers”.

This type of trading can be extremely damaging to a trader’s psychology through taking multiple stops outs, feeling constantly fraught and frequently experiencing the situation whereby the market has just stopped your out before reversing or you’ve been stopped out for the umpteenth time and give up on the idea before again the market reverses.

Another situation that is a frequent occurrence for counter-trend traders is that they will enter a move and the market will actually start to trade in their anticipated direction and because the trader has visions of catching a multi-tera turning point leading to thousands of pips of profit, they hold on to the trade only for the market to reverse and once again resume the trend and melt away all their profits.  Trading can be cruel.

The Path Of Least Resistance

Trading with the trend allows you to harness momentum and order flow in the market and follow the path of least resistance, instead of trying to fight against it. Once you properly understand the mechanics of price action and order flow and that most counter-trend moves are simply corrections or profit taking within a trend you will begin to understand that in the long run, your efforts are best deployed in trading with the trend and if you still have dreams of catching thousands of pips, you are far more likely to do so when you are on the right side of a long term trend.

Hone Your Skills, Understand Your Trade

As I mentioned earlier, trading counter-trend can be done once you have honed your skills and refined your knowledge. For the most part, whenever I trade counter-trend these days I do so in a far different manner from how I did in the early days. I understand that I am far more profitable trading with trend, but when I identify I solid counter-trend opportunity I am happy to take a very tactical, short-term trade. The key difference between my counter-trend trading and trend-trading is that with counter-trend trading I always trade with a target. Understanding that most counter-trend moves are merely corrections, I play for very specific levels, looking to bank pips before the trend resumes and the move reverses. When I trade with trend, I might be eyeing some major levels as rough targets but generally I am monitoring momentum and price action, looking to stay in the move until I feel a reversal is occurring.

Counter-Trend Trade

The counter-trend trade I took last week was a long in GBPUSD on Friday. I bought 1.4270, stop 1.4240 with a target of 1.4350.  The reason for this trade was that price had been in an extended down-trend for quite a while without any proper retracement and as such, a short term squeeze on positioning was likely to materialise. We tested a major support level, and having initially broken through, price came back above the 2010 low and reversed sharply higher, taking out the previous swing high.  This action alerted me that a squeeze was underway. As price then broke above key local resistance and the declining trend line, I bought the breakout targeting a move back up into key overhead resistance. I exited the trade at 1.4350 as per my plan, only for price to trade as high as 1.4362 before reversing lower.  gbplesson

Avoiding Mistakes

What’s funny is that as price was breaking out and hitting my target, I had some of the old feelings that perhaps this was the start of a major reversal and in the back of my mind I picture the move running on for another hundred pips or so. However, my days of trading emotionally and basing moves on “hope” are over and I stuck to my plan and exited at my target knowing that the longer term trend is still bearish and that price was likely to atleast stall at that resistance level. If there is a bigger reversal underway in Cable there will be plenty of opportunities to buy into it.

…This trade was called real-time in our Live Trading Room, part of our Trading Hub membership. If you;re interested in following all live trade calls as well as interacting with the LFX traders and other room members, check out our trading hub membership which is currently on 30 day free trial!