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:
- Identify a method that does a reasonably good job of identifying the longer-term trend
- 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|
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|
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|
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|
What an alert trader should be looking for is instances when:
- The 10-day moving average is above the 30-day moving average
- The latest close is above the 200-day moving average
- Today's oscillator is above yesterday's oscillator AND;
- 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.
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.)