When Counter-Trend Trades Make Sense (For Me)

When a security gets extended in one direction (why Zayn? why?) or another, there may be opportunity to take advantage of reversion to the mean by engaging in a counter-trend trade. Counter-trend trades, regardless of the timeframe, are lower probability by nature because you are attempting to trade against the underlying trend. Given the excitement in the currency markets and oil as of late, I thought it may be beneficial to explain what conditions I look for when attempting to capitalize on counter-trend moves.

1. The first step in my process is to find things that are extended from their mean, which for me is the 200 period simple moving average. Of course the threshold for it showing up on my radar is somewhat subjective based on what the security has done historically, but anything that’s ~ 20% or more above or below the 200 period simple moving average is a decent place to start.

2. Next, I want to look at some data regarding sentiment and seasonality, which I normally get from a service called sentimentrader. If sentiment is at historical extremes, that can help add some fuel to a short squeeze or sell-off that might occur if prices start correcting. From a seasonal perspective, I like to know how price behaves during certain months because small clues, such as prices ignoring what is normally a seasonally bullish period, can be a subtle hint from the market that there are larger forces at work.

3. After I’ve found something that’s extended and have a good handle on its sentiment and seasonality, I like to look at momentum using a 14 period RSI. What I’m looking for is a positive or negative momentum divergence, ideally on multiple timeframes, which for me is weekly and daily. Occasionally I might stay interested if there’s only a divergence on one timeframe, but for the most part I’d like to see it present on both.

4. As always, price is the most important variable. If the factors above look to be leaning toward one side of the trade, I’ll wait for price to give an entry at an area where I can clearly define my risk. Ideally, this is where I love to see a false breakout / breakdown. Not only do false moves often lead to fast moves in the opposite direction, but they provide a great risk/reward entry because I know exactly where I’m going to be wrong.

*Notice I used the word ideally quite frequently, that’s because very rarely will all of these factors line up perfectly, which is why there is some degree of subjectivity and room for error in these types of setups.*

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The Probability / Reward Trade-Off

One of the many things to consider in outlining a trading strategy is how you’ll address the trade-off between  probability and potential reward. In general, the higher the probability a trade is, the lower the potential reward. For example, if you attempt to anticipate moves, your potential reward will be higher than if you waited for confirmation, at the expense of having a lower probability. Some people are comfortable with that trade-off, while others are not. I’ll try to discuss below the three main scenarios I observe most commonly and briefly explain how I like to handle this “dilemma” in my own analysis.

Anticipating Breakouts / Breakdowns: 

Some traders like to buy or sell in anticipation of a stock breaking out or down. This gives them the advantage of a lower cost basis and more upside if / when it breaks out/down, but not without accepting the risk that the stock does not break in the direction they originally thought it would.

For example, LNKD’s recent action looked like a bullish consolidation pattern as it held a gap higher above the 2013 highs. An aggressive trader looking to anticipate this move might enter the trade with a stop somewhere below the recent lows, expecting to have a lower cost basis in the stock when it moves higher, thus increasing his/her reward. Although the probability of a breakout in the direction of the underlying trend is high, the probability of success for the trade overall is lower than if the trader waited for a breakout.

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Price Targets and Me

One of the main things that’s hammered into financial market participants’ minds is how to determine, and what to do, if you’re wrong. Something that I see discussed less frequently is what to do if you’re right. Now this topic encompasses a lot of material depending on how you think about the question, but for this post I want to discuss price targets.

If a stock starts moving your way, how do you know where to take profits? Unless your stock is on a one way trip to the moon, you’re going to need a plan for where to exit.

To me, a price target is defined as an area where the risk/reward of a stock is no longer in my favor to the degree I’m comfortable with.

There are a variety of ways to determine price targets including measured moves, Fibonacci retracements & extensions, prior support & resistance levels, levels on indicators, etc… There is no right or wrong way to determine price targets, it depends on your strategy, but it’s important to have some sort of method.

For me, I like to use measured moves, prior support & resistance levels and Fibonacci retracements & extensions to determine price targets.

Depending on the trades thesis, I think it’s important to have targets on each timeframe so you can avoid sitting through all the counter trend moves along the way. I look at markets on a weekly and daily timeframe, so I have structural targets (weekly) and tactical targets (daily) for every symbol I follow.

Structural Targets: I use the weekly timeframe to determine the long term trend and health of the overall market. This is helpful in identifying opportunities for investors and position traders with longer holding periods. It is also helpful to know what is going on on a higher timeframe when looking at the daily for tactical trading opportunities.

Below is a weekly chart of APPL. The trend was clearly higher with price above the uptrend line from the ’08 lows and a rising 200 week simple moving average. When prices broke above the ’12 highs and made new all time highs, I used the 161.8% extension of the ’12-’13 pullback to determine where I though prices would head next. Since then, prices hit my target so I’d be out, waiting for more consolidation or a pullback before getting involved again on the long side. Does this mean that I think AAPL’s major uptrend is in jeaporady? No, but the risk/reward at current levels is a lot less appealing up here than when it broke out.

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How I Use RSI

The Relative Strength Index, or RSI, is a popular momentum indicator used throughout the field of TA.

Rather than get into the definition and construction of this indicator, I think it’d be more helpful to go into how I personally use the indicator. If you need a refresher or are new to this topic, I suggest heading over to stockcharts chart school to familiarize yourself with it.

First off, I use a 14 period RSI for all the timeframes I look at because markets are fractcal, meaning that repeating patterns occur at all scales / timeframes.

The two main ways I use RSI are as follows:

1. Determining Bull / Bear Ranges

2. Identifying Divergences

Determining Momentum Ranges: If I can help it, I want to be trading in the direction that momentum is leaning. So how exactly do I define a bull or bear range? Well, it’s slightly subjective but anytime something hits overbought or oversold conditions and does not reach the opposite extreme on price consolidations or pullbacks I think of it as being bullish or bearish based on the original confirmation above 70 or below 30.

Bullish Range Example: When momentum is consistently hitting overbought, without reaching oversold.

bull rangeAs we can see from the chart above, after momentum transitioned into a bullish range by hitting overbought conditions in July 2013, AAPL continued higher in a nice uptrend. Since momentum never hit oversold conditions on pullbacks, that weakness ended up being a buying opportunity rather than a reason to be concerned if long or trying to be short.

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Natural Gas Mean Reversion?

Over the weekend I tweeted that I liked Natural Gas on a closing basis above $2.75 and got a few questions asking for an explanation. Here is my reasoning.

As with any financial market prediction, a timeframe needs to be defined. I expect this trade to play out over the next 3-6 months and therefore, by my definition, it is not a long term investment.

A look at a 10 year weekly bar chart of natural gas with nothing more than a simple moving average and a momentum indicator makes it clear why this is just a trade.

Natural Gas Weekly

  1. The 200 week simple moving average is declining.
  2. Momentum continues to confirm new lows in price and recently hit oversold conditions.
  3. Prices undercut the August-September 2012 lows and closed higher to confirmed support.

It doesn’t take any fancy system or strategy to see that structurally, Natural Gas remains in a downtrend. With a downward sloping 200 week sma and a lack of any positive divergence in momentum, it is going to be difficult for prices to sustain rallies.

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