One of the oldest adages in all of trading is that "the trend is your friend." This has become an old adage primarily by virtue of the fact that it is true. As the trend defines the prevailing direction of price action for a given tradable security, as long as the trend persists, more money can be made by going with the current trend than by fighting against it. Nevertheless, it is a natural human instinct to want to buy at the lowest price and to sell at the highest price. The only way to do this in the financial markets is to attempt to "buy the bottom" and "sell the top", which by definition is a countertrend approach to trading. (Check out some common technical indicators in 7 Tools Of The Trade.)

Each trading day the struggle between those attempting to buy or sell into an established trend and those attempting to buy near a low and sell near a high plays out. Both types of traders have very convincing arguments as to why their approach is superior. Yet, interestingly, in the long run, one of the best approaches might just involve melding these two seemingly disparate methods together. Often, the simple solution is the best one.
A Combined Approach
The key to successfully combining trend-following and countertrend techniques is twofold:

  1. Identify a method that does a reasonably good job of identifying the longer-term trend
  2. Identify a countertrend method that does a good job of highlighting pullbacks within the longer-term trend

While finding an optimum approach may take some time and effort, highlighting the potential usefulness of this concept can be done using some very simple techniques.

Combining the Two Approaches: Step No.1 – Identify the Longer-Term Trend

In Figure 1 you see a stock chart with the 200-day moving average of closing prices plotted. From a trend-following point of view we can simply state that if the latest close is above the current 200-day moving average then the trend is "up" and vice versa.

Figure 1: Price with 200-day moving average
Source: ProfitSource

However, for our purposes here we are not looking for a trend-following method that will necessarily trigger actual buy and sell signals. We are simply trying to pin down the prevailing trend. Therefore, we will now add a second trend-following filter. In Figure 2 you can see that we have also added the 10-day and 30-day moving averages.

Figure 2: Price with 10-day, 30-day and 200-day moving averages
Source: ProfitSource

So now our rules will be as follows:

1. If the 10-day moving average is above the 30-day moving average AND the latest close is above the 200-day moving average, then we will designate the current trend as "up".

2. If the 10-day moving average is below the 30-day moving average AND the latest close is below the 200-day moving average, then we will designate the current trend as "down". (Learn how to calculate a metric that improves on simple variance. Check out Exploring The Exponentially Weighted Moving Average.)

Combining the Two Approaches: Step No.2 - Adding a Countertrend Indicator
There are literally dozens and dozens of potential countertrend indicators that one might choose to use. For our purposes, since we are looking for short-term pullbacks within an overall longer term trend, we will use something very simple and relatively short-term in nature. This indicator is simply referred to as the oscillator. The calculations are simple:

A = the 3-day moving average of closing prices

B = the 10-day moving average of closing prices

The oscillator is simply (A – B)

In Figure 3, we see the same price chart as in Figures 1 and 2 with the oscillator plotted below the price action. As the underlying security dips in price, the oscillator drops below zero and vice versa.

Figure 3: Price with 3/10 oscillator
Source: ProfitSource

Combining the Two Approaches: Step No.3
So now let's actually combine the two methods we have described so far into one method. In Figure 4, see once again the same bar chart as in the previous three Figures. On this one we see the 10-day, 30-day and 200-day moving averages plotted on the price chart with the oscillator displayed below.

Figure 4: Looking for oscillator reversals to the upside in an established uptrend
Source: ProfitSource

What an alert trader should be looking for is instances when:

  1. The 10-day moving average is above the 30-day moving average
  2. The latest close is above the 200-day moving average
  3. Today's oscillator is above yesterday's oscillator AND;
  4. Yesterday's oscillator value was both negative and below the oscillator value two days ago.

Completion of this set of criteria suggests that a pullback within a longer-term uptrend may have been completed and that prices could be set to move higher. The aforementioned criteria presents a scenario in which the trend suggests that the stock is due to continue its upward momentum, yet the investor will not be purchasing shares at the very peak of the cycle.

The Drawbacks
There are many potential caveats associated with the method described in this piece. First and foremost is that no one should assume that the described method will generate consistent trading profits. It is not presented as a trading system, only as an example of a potential trading signal generation method. The method itself is simply an example of just one way to combine trend-following and countertrend indicators into one model. And while the concept is entirely sound, a responsible trader would need to test out any method before using it in the marketplace and risking actual money. In addition, there are other extremely important considerations to take into account that go well beyond just generating entry signals.

Other relevant questions to ask and answer before employing any trading approach are:

  • How will positions be sized?
  • What percentage of one's capital will be risked?
  • If and where to place a stop-loss order?
  • When should you take a profit?

The Bottom Line
This is just a sampling of considerations that a trader must take into account before beginning to trade any particular method. Nevertheless, with those caveats firmly in mind, there does appear to be some merit in the idea of combining trend-following and countertrend methods in an effort to buy at the most favorable times while still adhering to the major trend in play. (The moving average is easy to calculate and, once plotted on a chart, is a powerful visual trend-spotting tool. For further reading, see Simple Moving Averages Make Trends Stand Out.)

Related Articles
  1. Chart Advisor

    These Oil & Gas Stocks Have Reversed

    It's been a long downtrend for oil stock owners, but there's hope. These four oil and gas stocks have reversed and may keep trending to the upside.
  2. Chart Advisor

    Bumpy Roads Ahead In Transportation

    Investors are keeping an eye on the transportation industry. We'll take a look at the trend direction and how to trade it.
  3. Chart Advisor

    Agriculture Commodities Are In The Bear's Sights

    Agriculture stocks have experienced strong moves higher over recent weeks, but chart patterns on sugar, corn and wheat are suggesting the moves could be short lived.
  4. Chart Advisor

    4 European Stocks to Consider Buying

    European companies, listed on US exchanges, that are providing buying opportunities right now.
  5. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  6. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  7. Technical Indicators

    Why MACD Divergence Is an Unreliable Signal

    MACD divergence is a popular method for predicting reversals, but unfortunately it isn't very accurate. Learn the weaknesses of indicator divergence.
  8. Chart Advisor

    Weakness In Biotech Will Likely Continue

    You can breathe easy with your biotech holdings--assuming you aren't counting on them to make you rich.
  9. Chart Advisor

    Expecting a Big Breakout In These 4 Stocks

    These stocks are tightly wound following big moves, and upon breakout more big moves could ensue.
  10. Chart Advisor

    Trade Base Metals With These 3 ETFs

    News out of Alcoa is causing active traders to turn toward base metals for opportunities. Before diving into the market, check out the charts of these three ETFs.
  1. What are the best technical indicators to complement the Force Index?

    The force index is an oscillator that generates trading signals by producing a value that fluctuates around a center value ... Read Full Answer >>
  2. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  3. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  4. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  5. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  6. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!