Managing Countertrend Trades

Countertrend trades are lower probability by nature, which means that risk management is vital both when they work and when they don't. Taking the loss and re-evaluating when the trade thesis is invalidated is something that most traders think about, but managing risk on a trade that begins to work right away is just as important and not discussed as often. Today, I want to look at the importance of managing positions that begin working right away so that we can avoid winning trades turning into losers.

Monday, we outlined our bullish thesis toward Indian equities and provided a number of countertrend and breakout trades for our subscribers, many of which began to work right away and are now sitting between their risk management level and upside price objectives. So the challenge now becomes determining how can we manage these trades so that we give them enough room to work but also don't allow them to turn into losers if they should reverse from current levels.

The first and most important step is to make sure your position is sized correctly for your risk profile and market approach. If you're trading too big, you're more likely to make decisions based on emotion rather than your process. Additionally, if the position turns against you, then you may sustain a significant drawdown or be knocked out of the game entirely. Capital preservation is just as (if not more) important than capital appreciation because you can't play without having any chips to bet with.

[Learn more about risk management techniques that can help you protect your profits and avoid losses in my Technical Analysis course on the Investopedia Academy.]

So if your position is too big (even if the trade is working), do yourself a favor and scale it down to the appropriate size. Even if it works once or a few times, a lack of adherence to your risk management process will always come back to hurt you in the end.

Before we get into a winning trade, I want to provide an example of a losing trade. It's the exact same setup as I'll talk about below (failed breakdown and bullish momentum divergence), but it had no upside follow-through. Prices were back above former support for three days and quickly reversed. Will it eventually work? Who knows, that's not our problem. Our original thesis was to be long only if prices were above that former support level, and they're not, so we take the loss and move on.

Chart showing the performance of Jagran Pakistan stock

Depending on our exact entry into the losing trade, some of the methods discussed below could've helped reduce our risk and limit our losses once we the trade ultimately confirmed it wasn't working. So keep that in mind as we walk through this next example.

Now onto managing a winning trade. Let's use the example of VRL Logistics Limited (VRLLOG.BO). Prices broke below former long-term support, momentum diverged, and prices based tightly before finally confirming a failed breakdown. This defined our risk at 259.50 Indian rupees and gave us an upside target near 310 rupees.

Chart showing the performance of VRL Logistics stock

The stock immediately started to move and is now sitting near 274 rupees, roughly 15 points above our risk management level and 36 points below our upside objective. While we want to give it room to run, we don't want to allow this to turn on us ... especially in the current environment. So we have a few options.

The first option in trades like this that start to work immediately is to "feed the ducks." This refers to taking profits on enough of the position so that, if your original stop is hit, the initial profit taking offsets any losses. It essentially becomes a risk-free trade.

Another option is to use something like a trailing stop or volatility-based stop that takes you out of a position when the trend you're looking to capture is no longer intact or if volatility expands to a level that you're no longer comfortable with.

A third choice is to use a time-based stop, given that these types of trades tend to work best when there's fast upside follow-through after it confirms.

Regardless of whether you choose one of these methods, something else or a combination of a few, the underlying message is clear. It's just as important to manage your risk when you're right as it is when you're wrong, especially when trading against the primary trend.

Thanks for reading, and let us know your thoughts!

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