Counter-trend trades are one of the hardest ways to make money.That’s because traders fight an uphill battle and their timing needs to be flawless, otherwise they get run over. Despite these overwhelming odds, all too often traders cannot resist the temptation to argue with the market. In this post I will help you understand why counter-trend trading is so difficult, when it is okay to go against the trend, and the risks you face when doing it. Knowledge is power and the more you know going in, the better chances you have of coming out the other side alive, and maybe even with a little extra money in your pocket.
As I wrote in a previous educational post, most traders don’t understand contrarian investing. Too many people mistakenly believe contrarian trading is going against the trend. Nope, the trend has nothing to do with it. Contrarians go against the crowd, not the trend. Big, big difference and if you are a little unsure, check out my previous post.
There is nothing wrong with a stock or index that goes up. That’s how the S&P500 went from 100 to 200, 500 to 1,000, and why we currently find ourselves above 2,500. If an investor knows nothing else, smart money bets on the market going higher because that is what it does. Blame inflation, productivity, money printing, or anything else, it doesn’t really matter. Markets go up more than they go down and that’s all that matters to the long-term investor.
But we’re traders and we want to trade. We don’t want to sit idly through every gyration. Not only do we want to skip the next pullback, we want to profit from it by shorting the decline. Everyone knows markets go down, especially after it goes up “too much”. Unfortunately that overly simple logic costs a lot of smart people a lot of money.
Markets move in waves and I cover this another educational post, but suffice to say every bit of up is followed by a normal and healthy bit of down. Trading these waves is not a bad thing as long as we keep selling high and buying low. Unfortunately that is a lot easier to say than it is to do.
For beginners, the best way to swing-trade is to ride the wave up, sell when after a nice run, and then wait to buy the next dip. This way you are always trading alongside the trend. If you buy a little too early or late, it doesn’t really matter because mistakes are fixed by waiting it out. Did the market keep going down after you bought the dip? No problem, just wait for the rebound to erase your losses. Hold a little too long and the market fell under your buy point? No worries, simply wait for the next wave higher.
Counter-trend traders don’t have these same protections. If they screw up and don’t exit immediately, the losses only get bigger as the market marches away from them. Short an uptrend at the at the wrong time and the more stubborn you are, the more money you lose.
I will be honest, I short bull markets. But I also acknowledge this is a low-probability trade and am doing it more for entertainment than to make money. But as long as I pick the right entry point, the risks are manageable.
The key to surviving counter-trend trades is to assume a trend will continue and it requires proactive timing. Short a move to the top of the range, not a violation of the lower end. As I said earlier, markets move in waves and the best short opportunities are when everyone is fat and happy. By the time traders are nervous and the headlines dire, it is too late. At that point a smart traders is thinking about buying the dip, not shorting the weakness. And when counter-trend trades show a profit, get paranoid of a rebound and start looking for an excuse to cash-in.
Remember trends continue countless times, but they reverse only once. The odds always favor a continuation of the previous trend and smart traders stick with the high probability trade.
There are ways to identify a trend that is dying and about to reverse. That sounds like an excellent topic for another blog post! Signup for Free Email Alerts so you don’t miss it.
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Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.