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.*