What Is Countertrend Trading?

Countertrend trading is a type of swing trading strategy that assumes a current trading trend will reverse and attempts to profit from that reversal. Countertrend trading is generally a medium-term strategy in which positions are held between several days and several weeks. Countertrend traders rely on envelope channels (such as Bollinger Bands), indicators (such as the Aroon Indicator) and oscillators (such as the Relative Strength Index or Chande Momentum Oscillator) to make their decisions. Traders may use countertrend strategies for a variety of purposes including pure profit, diversification and risk management.

Understanding Countertrend Trading

A countertrend trading strategy takes investment positions inverse to the current trend. This strategy can be used at any time but is often most commonly used when a trader sees strong potential for a reversal. Generally, countertrend trading may also be referred to as swing trading which refers to the opportunity to take advantage of a trend that reverses or swings in a new direction.

Some traders will use a countertrend trading strategy when they think a market or security is overbought and due to pullback or is oversold and due to bounce.

Countertrend Trading Strategies

Countertrend trading strategies are complex and therefore typically only used by advanced traders. They may be used for diversification and risk management or forward-looking predictions.

Diversification and Risk Management

Active traders are cautious about the percentage of their portfolio they risk on each trade with the 2% rule being a well-known practice across the industry. Advanced active traders that trade according to technical signals will typically formulate grid trading strategies. The strategies place small trading bets throughout a trend, specified at intervals when the price increases or decreases in order to manage their risk. Conceptually, countertrend grid strategies taking inverse positions can also be a way for traders to manage risk.

Some contrarian active traders choose to fully focus on a countertrend trading strategy. These traders believe that by buying (rather than selling) into a bearish downtrend can payoff with a bounce. They may also take short positions into an uptrend, rather than buying, in an effort to potentially catch a reversal in trend.

Forward-Looking Predictions

Another type of countertrend strategy most comparable to swing trading can be implemented when an investor seeks to take countertrend positions at resistance or support price points in the future. This type of strategy takes bets that the trend will swing to a new direction and their positions will profit accordingly.

A forward-looking countertrend strategy often requires the advanced use of conditional orders. Conditional orders allow an investor to specify a selling price near resistance levels or a buying price near support levels. Advanced conditional orders allow an investor to use a variety of both standard orders and option orders to specify a profitable price. Advanced conditional orders can also be programmed as bracketed orders which are executed when a reversal occurs and include upper and lower conditions to manage potential profit and loss.